For some industries, the general rules of thumb are a solid way to gauge where your company might stand in relation to its competitors. Therefore, comparing key industry measures to one another can help you determine whether or not your business is functioning successfully.
Numerous businesses come from various sectors of the economy. Despite the fact that every company is unique, the method for obtaining a valuation is the same regardless of the sector.
There are different calculations that valuation analysts employ to carry out the valuation for businesses in various industries. The various components of the business valuation are calculated using the following formulas:
(Net Sales= Annual Gross Sales, net of returns + any discounts)
The most common valuation metric is the sales multiplier, which compares your total sales to those of comparable businesses and their sales multiples. This statistic was primarily utilised by small and medium-sized businesses to determine their valuation.
(EBITDA= Operating Profit and Deprecitation & Amortization)
Earnings Before Interest, Taxes, Depreciation, and Amortization is referred to as EBITDA. Finding the value of medium-sized to large firms typically uses this method. By eliminating the costs that bias a fair comparison, investors may compare your company to others in the same industry.
(SDE= Operating Profit + Owner’s compensation+ Depreciation & Amortization)
Seller’s discretionary profits is referred to as SDE. The most typical multiple used to appraise small firms is this one. Using this, you may tell someone who wants to buy your company how much money they would make working there.
Gross Profit Multiple
(Gross Profit= Net Sales- Cost price of the goods)
Companies that are losing money can benefit the most from using the gross profit as a method of assessment, but the gross profit also provides a useful indication of the company’s overall value.
And with that, we’re done with the formulas. Let us take a look at the pros and cons of this valuation method.
Pros and cons of the rule of thumb valuation approach
The rule of thumb valuation approach has both advantages and disadvantages. It’s crucial to understand both the advantages and disadvantages of this strategy and when it will and won’t be effective.
- The method is clear-cut, easy to understand, and quick to implement.
- Saving time and money by figuring out the worth
- In buy-sell agreements, the general rules of thumb are occasionally mentioned to help parties understand the value they would get upon the transfer of equity.
- The method may contain unstated assumptions about a company’s risks and profitability, which could result in an inaccurate valuation and a decline in price.
- The balance sheet’s main things are not reflected in it (such as debt levels, real estate, non-operating assets, or cash on hand)
- The rule of thumb might lead to inaccurate judgements and estimations because of occasional shortcomings.
Business shareholders have a special tool that allows them to estimate the worth of their ownership stakes. They have the chance to quickly and cheaply determine the general value of the company. Shareholders should exercise caution, utilise the strategy sparingly, and avoid relying solely on the rule of thumb valuation.
Remember that it is essential to be aware of the constraints and internal workings of the valuation process.