If you’ve been looking to find how much your business is worth, you might have come across something called a rule of thumb business valuation. 

It is a quick way to estimate your business’s worth. All you’ve got to do is apply an industry-specific percentage or multiple to a financial figure, such as annual sales or SDE and EBITDA numbers. 

However, rule of thumb valuation methods also have limitations. 

Yes, they come in handy for getting a rough idea of a business’s value or checking whether a sale price is reasonable. But they are not enough when you need a defensible valuation for a sale, buyout, tax matter, litigation, financing, or succession planning. 

In this blog, I have explained the most common rule of thumb valuation methods, how they work, and their advantages and limitations. 

So, read on to know which method makes the most sense for valuing your business. 

Key takeaways

• Rule of thumb valuation provides a quick, rough estimate of business value.
• Common valuation methods use revenue, SDE, EBIT, or EBITDA.
• The right multiple depends heavily on the industry and the business itself.
• A rule of thumb is useful as a starting point, but not as a complete valuation.
• A professional valuation is the better choice when you’re valuing your business for sale, merger, or acquisition. 

What is a rule of thumb business valuation?

A rule of thumb business valuation is a quick way to estimate what a business might be worth using an industry-specific benchmark.

Here, the calculation is simple. You take a financial measure, such as annual revenue or Seller’s Discretionary Earnings (SDE), and apply a percentage or multiple to it.

For instance, let’s say you are valuing a chiropractic practice. Now, if chiropractic clinics typically sell for 40% of annual revenue and your business generates $1 million in annual revenue, the rule of thumb valuation estimate would be $400,000.

Similarly, if your chiropractic clinic has $300,000 in SDE and similar clinics sell for 3 times SDE, your estimated business value would be $900,000.

Now, there isn’t one rule of thumb for selling a business that works for every company. That’s because different industries use different benchmarks such as revenue percentage, multiple of SDE, EBIT, or EBITDA. 

Pro tip: If you want to estimate your business’s value using rule of thumb company valuation, don’t simply take any random multiple you found online and apply it to your business. Instead, I suggest you start with making sure the rule is relevant to your industry and business model. 

What are the most common rule of thumb business valuation methods?

There are several ways to use a rule of thumb when estimating the value of a business. This incudes: 

#1. Revenue or sales multiple

This is the simplest business valuation rule of thumb. Here, you take a company’s annual sales, preferably based on the most recent 12 months, and multiply them by an industry-specific percentage.

For instance, if a company does $1 million in annual sales and similar companies sell for 40% of annual revenue, the rule of thumb valuation will be $400,000. 

Here’s how:

$1 million (annual sales) × 40% = $400,000 estimated value

The biggest advantage of this method is that a company’s revenue is much easier to verify than its adjusted earnings (like SDE). That’s because you don’t have to make numerous add-back decisions. 

However, the biggest limitation of this method is that revenue alone doesn’t tell you how profitable a business is. A company generating $1 million in revenue with $300,000 in profit is obviously very different from one generating the same revenue but barely breaking even.

#2. SDE multiple

Another common rule of thumb valuation method popular with smaller owner-operated businesses is to apply a multiple to Seller’s Discretionary Earnings (SDE).

For instance, if your business generates $250,000 in SDE and comparable businesses sell for 3 times SDE, you’ll multiply $250,000 by an SDE multiple of 3. This will give you a valuation of $750,000. 

Here’s how:

$250,000 (SDE) × 3 (multiple) = $750,000 (valuation)

This approach is useful because SDE shows the financial benefit available to an owner-operator.

However, you need to calculate SDE correctly before applying the multiple. That’s because owner compensation, non-recurring expenses, non-operating items, and other adjustments can all affect the final figure.

#3. EBITDA multiple

Larger businesses are mostly valued using an EBITDA multiple.

Here’s the basic calculation it uses:

EBITDA × appropriate industry multiple = estimated business value

For instance, a business with $1 million in adjusted EBITDA and a 5x EBITDA multiple will be valued at $5 million.

$1 million (EBITDA) x 5x (EBITDA multiple) = $5 million (valuation)

EBITDA-based multiples are more relevant when the business has an established management team and isn’t dependent on the owner.

#4. EBIT multiple

EBIT stands for earnings before interest and taxes and is another way of measuring operating earnings. A lot of companies use EBIT multiples as a rule of thumb business valuation benchmark.

Here, the total value of a company is calculated as market capitalization plus total debt minus cash. You take the company’s adjusted EBIT and multiply it by an appropriate industry-specific multiple.

For instance, if a business generates $500,000 in adjusted EBIT and comparable businesses sell for 4 times EBIT, the estimated business value will be $2 million.

Here’s how: 

$500,000 (EBIT) × 4 (multiple) = $2 million (estimated value)

In short, here are all the rule of thumb business valuation methods: 

What are the limitations of a rule of thumb valuation?

A rule of thumb valuation is useful because it is simple. But this is also its biggest weakness.

You see, a typical rule of thumb business valuation method takes just one figure and simply multiples it to an industry-specific. And it doesn’t completely account for everything that makes your business different from another business in the same industry.

For instance, two car wash facilities could be generating $1 million in annual revenue. But one might have recurring customers, strong profit margins, an experienced management team, and little owner dependence. 

On the other hand, the other might depend almost entirely on one big taxi company responsible for a large portion of its revenue, and operate with much thinner margins.

Now, using the same company valuation rule of thumb for both businesses will produce the same estimated value, even though a buyer will view the two companies very differently.

Overall, here are the biggest limitations of business valuation rule of thumb:

#1. It doesn’t account for business-specific risks

A rule of thumb is based on broader industry data. It doesn’t account for things like customer concentration, owner dependence, declining revenue, pending litigation, or weak management depth. 

#2. It depends on the quality of your financials

The number you multiply is just as important as the multiple itself. So, if your SDE or EBITDA hasn’t been properly normalized, your estimated value can be significantly off.

You’ll need an experienced business valuation expert in this case for an accurate audit and estimation. 

#3. It doesn’t tell you which multiple to use

Even when you find an industry-accepted benchmark, you will still see a range of multiples like 2x, 2.5x, etc., rather than one fixed number.

So, which multiple should you choose?

You need to look at the actual business to make that decision. 

A company with strong recurring revenue and low owner dependence can justify a higher multiple than another company in the same industry with declining sales and major key-person risk.

#4. It might not be appropriate for formal purposes

A rule of thumb can be useful for an initial estimate. But it isn’t a substitute for a formal business valuation when the value is needed for things like litigation, estate and gift tax matters, or buy-sell decisions. 

When should you use a rule of thumb valuation?

A rule of thumb business values can be a useful starting point.

For instance, if you’re thinking about selling your business and you want a rough idea of what businesses like yours are selling, you can use a rule of thumb method. 

Similarly, if you want to buy a business, a rule of thumb can help you determine whether the asking price is reasonable.

It can also be useful when you’re simply trying to get a general idea of your company’s value.

But if you’re making an important financial or legal decision based on the value of your business, you will need a professional business valuation.

Which rule of thumb valuation method is the best?

There isn’t one rule of thumb valuation method that is best for every business. The right method depends on the type of business, its size, how it makes money, and which financial metric best represents its earning potential.

Here’s how I suggest you choose a rule of thumb valuation method based on your business:

A. For smaller, owner-operated businesses: SDE is the most practical starting point because the buyer is purchasing both the business and the ability to earn a living by operating it. SDE captures the total economic benefit available to that owner-operator.

B. For larger, professionally managed businesses: EBITDA is more appropriate because the business can operate without the current owner being involved in every day-to-day decision. Here, the buyers are more interested in the company’s normalized operating earnings than the personal financial benefit available to the owner.

C. For businesses with limited or negative earnings: Revenue is a useful benchmark. This is especially true for high-growth or early-stage businesses where current earnings don’t yet reflect the company’s potential.

FAQs about rule of thumb business valuation

What is the most common rule of thumb for valuing a business?

There isn’t one single rule. Smaller owner-operated businesses are often valued using SDE multiples, while larger businesses are evaluated using EBITDA multiples. Some industries also use revenue-based rules of thumb.

How do you value a business using a rule of thumb?

You multiply an industry-specific benchmark by a relevant financial measure, such as revenue, SDE, or EBITDA.

For instance, $300,000 in SDE (Seller’s Discretionary Earnings) multiplied by a 3x industry multiple will give an estimated value of $900,000.

Is a rule of thumb accurate for business valuation?

It can provide a useful starting point, but it isn’t an accurate measure of a company’s value.

That’s because a rule of thumb doesn’t fully account for company-specific factors like growth, customer concentration, profitability, management depth, or owner dependence.

What is a good rule of thumb for selling a business?

The best rule of thumb depends on the industry and the type of business you’re selling.

An SDE multiple can be appropriate for a small owner-operated business, while an EBITDA multiple will be more relevant for a larger professionally managed company.

Conclusion

As you can see, rule of thumb business valuation is a convenient way to get a quick idea of what your business might be worth.

But I suggest you don’t treat it as a universal formula or a reliable approach when buying or selling a business. 

If you’re planning to sell your business or need its value for a buyout, tax matter, litigation, succession planning, there is no substitute to a professional valuation. 

Got more questions or want to determine what your business is really worth?

You can get in touch with us!

At Arrowfish Consulting, we are seasoned business valuation professionals with 2+ centuries of combined expertise. We will analyze your financials, determine the best valuation method, and provide a well-supported current market value of your business.

Jeremiah Grant

Jeremiah Grant is the Managing Partner of Arrowfish Consulting. In addition to acting as a primary liaison for many of the firm’s engagements, He primarily focuses on business valuation and economic damages expert witness assignments, in addition to forensic accounting and insurance claims analysis.

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