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Business Valuation Principles – Rule of Thumb

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Business Valuation Principles – Rule of Thumb

Rules of thumb are commonly used for professional services firms, medical practices and dental practice business valuation Canada. There are advantages and disadvantages when using a business valuation rule of thumb method.

But remember, no two businesses or practices are alike even when the revenue or sales generated by the practices are similar. We need to look beyond revenue and examine the financial statements in detail in order to arrive at a business valuation conclusion.

What is a business valuation and how do you value a business?

Business valuation Canada is based on the concept of fair market value. Fair market value is  ‘the highest price available, in an open and unrestricted market, between informed parties acting at arm’s length under no compulsion to act expressed in terms of money or cash equivalents.’  The fair market value of a business is assessed by utilizing several various valuation principles:

  • Value is point-in-time specific
  • Value is prospective (that is based on future earnings)
  • The more liquid the business, the higher the value
  • The higher the net tangible assets of the business, the higher the value

A corporate business uses the above principles to come to an estimate on the business value. Once they come to an estimate a valuation approach needs to be decided on. There are three valuation approaches:

  • Asset approach – the assumption that a buyer would not pay more for the assets of the business then the cost to emulate those assets. This approach is based on factual data and money spent. This approach is hindered by the fact that it does not convey the value-added.
  • Market approach – Precedent transactions and public company multiples are used as a benchmark to value the business, however, there are limitations to this approach. It is difficult to find information on companies that are private.
  • Income approach – Uses the financial information of the company to estimate fair market value. This type of approach is disadvantageous for start-up business in the early days of the business as the cash flow may be low vs a company that has been in business for several years and has a lot more to show regarding its financial history.

A business valuation consists of the net tangible assets (inventory, land), identifiable intangibles (clients, copyrights), goodwill and redundant assets (additional cash not needed to keep the business going, property owned by the business).

Advantages – Rule of Thumb Business Valuation in Toronto

Business Valuation Principles – Rules of Thumb
  • Low cost: by using an accepted rule of thumb to value any type of business, in Toronto, a practice owner or prospective owner can arrive at a valuation estimate without incurring the cost of a professional.
  • Time: using a business valuation rule of thumb will help the parties involved in acquisition and sale quickly arrive at a valuation estimate.

Disadvantages – Rule of Thumb Business Valuation in Toronto

  • Timing: We recently met with a doctor that had owned her practice for over 20 years and she was considering retiring. The first time she was exploring opportunities to acquire an existing practice the rule of thumb was 1 x practice revenue. But times change. The business valuation rule of thumb 20 years ago likely does not apply today.
  • Business valuation based on a rule of thumb is not an economically derived conclusion. The business valuation of practice should be based on the earning potential of the practice – not strictly based on the most recent year’s revenue. A business valuation conclusion from a professional accountant will consider the past five years of financial performance as well as a consideration of future performance.

Example

  • Medical practice A generates $500,000 in annual gross billings
  • Medical practice B generates $450,000 in annual gross billings

If we apply a rule of thumb multiplier to arrive at a business valuation estimate, the value will be quite similar: 1.5 x $500,000 =  $750,000 implied value and 1.5 x $450,000 = $675,000 implied value. But we need to consider other elements:

  • Location: location affects the business valuation of a practice in several ways. Geographical location will determine leasing costs based on the market rents in the neighbourhood and it will also affect the size of the client base.

Consider that both practices have leased commercial space of 2,000 square feet. Practice A is located in Midtown and pays $50,000 annually in leasing costs, but the similarly sized practice B is located in Stouffville and has annual leasing costs of $20,000. There is a $30,000 difference in annual overhead costs and that will significantly affect the business valuation estimate.

All other expenses being the same, Practice A has before-tax earnings of $150,000 while practice B has before-tax earnings of $180,000. If we apply the same business valuation multiple of 5 to the before tax earnings of each practice we arrive at a business valuation estimate of $750,000 for practice A and $900,000 for practice B. This is big difference in business valuation from the estimate derived based on rule of thumb!

Other Considerations

Business Valuation Principles – Rules of Thumb
  • Staffing costs: Location will also affect the staffing and administrative costs of a professional services firm or medical practice. Salaries will be higher in places with high cost of living and lower elsewhere. This is an important consideration if you are considering an acquisition.
  • Competition: Sometimes owning a business or a professional or medical practice in a rural location can be quite profitable despite a limited client base. Consider the competition per capita. Toronto is a desirable place to own a practice because of the influx of residential development, but there has also been a significant increase in competition.
  • If you are an individual considering an acquisition in Toronto and have concerns about business valuation ask the seller for financial statements, and if it is an incorporated business, the corporate tax returns. Ideally you will want to have access to the previous five fiscal years’ financial information.
  • Revenue only tells part of the story. In the example above we showed that if revenue is similar between two businesses, the business valuation estimate could be quite different based on other aspects of the operations.

Frequently Asked Questions

What is the formula for the valuation of a business?

The valuation consists of the following elements; net tangible assets + Identifiable intangibles + Goodwill + Redundant Assets.

What is the multiplier to value a business?

A multiplier is usually 1 to 1.5 times the gross annual revenue or a set fee per patient or based on your industry rule of thumb multiplier.

How do you value a private company?

A private company or small business is valued by the industry rule of thumb. Rule of thumb is usually based on a multiple of sales performance. Used commonly for professional service firms, medical and dental practice valuations. A thorough examination of financial statements beyond just revenue needs to be conducted by a professional financial advisor before arriving at a business value conclusion.

How do you value a business?

In Canada, the valuation is based on the Fair Market Value. The fair market value is assessed by several various valuation principles – value is point-in-time specific, prospective, the more liquid the business the higher the value and the higher the net tangible assets the higher the value. A valuation consists of the net tangibles, identifiable intangibles and goodwill and redundant assets. Please see the ‘What is a business valuation and how do you value a business?’ for more information.

What are the 3 ways to value a business?

You can valuate a business by the asset approach, market approach or the income approach.

 

 

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