Business Valuation Pitfalls: Using Rules of Thumb to Value a Business

Many business buyers try to use a rule of thumb to value a business. This is a valuable tool but if you actually try to purchase a business based on it, you are sure to regret it later. Last week I received a call from an experienced restaurant manager that wanted to buy his own restaurant. He wanted me to confirm that restaurants were selling at 3 to 5 times net profit. I told him that they were not selling in that range in the current market. He insisted that he had seen comparable to prove they were. I thought this would be an interesting subject for an article.

Rules of Thumb – Business Valuation Pitfall?

When valuing a restaurant or any business by using rules of thumb you need to have an accurate profit figure. This is rarely available. There are so many definitions for net profit that there is a book used in the IBBA (International Association of Business Brokers) training class to teach calculating profit that it is actually 6 inches thick. This is not a book for CPAs but just business brokers.

Lets assume we have now come up with a profit figure that works for our purposes. The rule of thumb must clearly specify what profit figure it is based on. There are “Sellers Discretionary Earnings” EBIT (Earning before interest, and taxes but after reasonable salary for the owner) and “EBITDA” (Earnings before interest, taxes, depreciation and amortization) just to name the 3 major profit figures used by business brokers. The rule of thumb, if one exists is different for each of these three methods.

Lets assume you now have a profit figure and a rule of thumb. Lets assume the rule of thumb is 3 times net profit.

The problems with rules of thumb still would have to be addressed. Rental amount, type of restaurant or business, franchise or not, all are not addressed by a rule of thumb. Would you pay the same price for a restaurant with $2,000 rent as $10,000 rent even if they both had the same bottom line? I wouldn’t. $50,000 is a salary not a business investment.

The next big issue then comes forward: Would you pay $150,000 for a business clearing $50,000 with the owner working 60 hours a week, if there were similar businesses available for $450,000 that were making $150,000 profit, with the owner working 60 hours a week?

I hope this is of some help in navigating the river of misinformation floating around regarding how to value a business.

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