The rule of thumb business valuation approach values the subject business based off of the selling price data from recently sold similar businesses. The concept of valuing a business in this manner is similar to how homes are valued in the real estate market. Typically, homes are valued relative to recently sold homes in the area, with the recently sold homes’ data adjusted to be more comparable to the subject home to be sold. By applying this same principle to the business valuation market, the goal is to calculate a business valuation that reflects the fair market value, or the “going rate,” in the market within which the business is operating.
A key consideration here is to utilize aggregated comparables data, adjusted for an apples-to-apples comparison. If data from only a few specific recent transactions in the market are used as a comparison, then it is quite likely that other, unknown factors that are impossible to verify, specific to those deals, might have heavily impacted the sales price. That is the reason why a large, accurate database is necessary for the market method of business valuation.
The subject business’s financial data is also very relevant for this business valuation method. It is key to find an accurate cash flow metric, usually the seller’s discretionary earnings (SDE) for small businesses with less than $2,000,000 in sales, to multiply by the comparables multiplier. After all, it will be counterproductive for a business buyer to calculate an inaccurate valuation by making an error on the primary input variable (near-term expected cash flow).
How is it calculated: Choose the appropriate expected future cash flow then multiply that figure by the appropriate multiplier
When to use it: if the subject business is generic and the market has a large amount of accurate comparables data available to use. Additionally, it helps to answer the question of ‘does this make sense?’ if there is a different valuation or price to compare it to.