Lesson 3. Why Rules-Of-Thumb Do Not Work

Every owner we've ever worked with has a "guesstimate" what his or her business is worth; those guesstimates are almost always based on a rule-of-thumb. The most important message we can share is that rules-of-thumb are always wrong. Consider this fairly typical statement taken from the website of a law firm:

"A good rule-of-thumb is that a health care practice is worth anywhere from one to four times its net earnings. A practice netting $300,000 after expenses might be worth anywhere from $300,000 to $1.2 million."

Should you list your business for $300,000 (but if it is worth $1.2 million you would be leaving a lot of money on the table)? Or should you list it for $1.2 millon (but if it is worth $300,000 you will scare away your prospects)? Rules-of-thumb are not the answer; a good valuation done by an experienced professional is. Click on the link to learn more about how SPARDATA values a business like yours.

Let's examine rules-of-thumb to understand why they should not be relied upon. Take two dry cleaners in the same town, both doing $1 million in annual sales. The dry cleaning industry rule-of-thumb is that "a shop is worth one times annual sales", so that suggests both shops are worth $1 million. In fact a professional appraiser can look at these two shops and conclude one is worth twice the other. How is this possible? How can two businesses in the same industry in the same town doing the same sales have different values? It turns out it is easy:

Dry Cleaner #1 is a brand new store located in an upscale part of town. Last year it did $500,000 in sales, this year $1,000,000, and next year it expects to do $1.5 million. Its equipment is spanking new. It has good aggressive management. Everything about this business is trending upwards.

Dry Cleaner #2 is located in a bad part of town. A few years ago it was doing $2 million in sales, now it is down to $1 million. The roof leaks. The property, plant and equipment is old and needs repairs. Basically everything about this business is trending downwards. Two businesses, same industry, same sales - completely different values. But a rule of thumb never picks up on that. That is why owners should never base the value of their businesses on a rule of thumb.

Lesson 1: Owners Make Bad Appraisers
Lesson 2: Ignorance Is Costly
Lesson 3: Why Rules-Of-Thumb Do Not Work
Lesson 4: I Will Ask My CPA
Lesson 5: How Appraisers Value A Business