Business Valuation Principles – Rules of Thumb
If you are a private business owner in an industry with a high volume of competitors you have likely heard how to value your small business or practice based on the industry rule of thumb. Rules of thumb are typically based on a multiple of sales performance. For example, 1 to 1.5 times gross annual revenue or a set fee per patient.
Rules of thumb are commonly used for professional services firms and medical practice and dental practice business valuation in Toronto. There are advantages and disadvantages when using a rule of thumb method of business valuation.
But remember, no two business 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.
Advantages – Rule of Thumb Business Valuation in Toronto
- Low cost: by using an accepted rule of thumb to value a medical practice or dental practice in Toronto, a practice owner or prospective owner can arrive at a valuation estimate without incurring the cost of a professional.
- Time: using a rule of thumb will help the parties involved in an 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. In our consultation with her, she mentioned that when she first was looking to acquire a practice the rule of thumb was 1 x practice revenue. But times change. The 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 a 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 will consider the past five years of financial performance as well as a consideration of future performance.
- 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!
- 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.