Is there a standard method to estimate the value of any business? This is the most-asked question I get at conferences. Wouldn’t it be useful to employ a standard metric to universally calculate the correct value? Yes, every business is worth exactly 2.7563x its cash flow! Or maybe not….
Rules of Thumb
A rule of thumb (ROT) for valuation is a general procedure based on practical experience, rather than extensive evaluation. The ROT is an approximate measure that is used to quickly provide an estimate, make a decision or solve a problem. The ROT is used as a way to estimate value , especially in situations when more precise methods are not practical or available. ROTs are not intended to be used as a basis for a final decision, , but rather as a starting point or a rough guide to help with decision-making.
Business valuations are a combination of data and judgment. There is no simple formula to determine an accurate value of a business. For example, let’s say it is December 31, 2019 and your business is running a cruise ship. The value at Dec 31, 2019 would be drastically higher than the value of the same business in March 31, 2020. At Dec 31, 2019, we didn’t know there was a pandemic brewing; by March 31, 2020 the cruise industry was moored. Lockdowns were imposed by governments at every level; tourist demand for cruise-ship holidays sank. The events in the spring of 2020 resulted in an extreme and unforeseen change in business value.
Judgement is more context driven and is qualitative in nature. How does one cruise ship company compare to others? Is this one more popular? Does it have better service? Are its ships equally passenger friendly? Does it travel to popular destinations? In general, the qualitative criteria are discovered and resolved through analysis of markets and the financial performance of the business. Cruise ship companies having a similar number of similar ships (productive assets generating revenue), should have similar revenue – but may have drastically different profitability.
Sunny Sailing vs the Stormy Seas
As an example, imagine two cruise ship companies for sale: Sunny Sailings and Stormy Seas. Both companies have one ship that has 100 berths. The ships are the same model, made by the same shipyard , are nearly the same age, and each has similar operating costs. Sunny Sailings sells out every berth on every cruise – 100% utilization of productive assets. Stormy Seas only sells 70% of berths and needs to provide incentives to get customers to sail with them. The price of a berth on Sunny and on Stormy is $100. Since the productive assets are similar, the fixed costs of $5000 are going to be similar for both companies.
The result will be Sunny Sailings is profitable and Storm Seas is less so. In the end, if both companies were up for sale, Sunny Sailings would sell for a much higher price. Sunny Sailings is more profitable and lower risk.
Sunny is lower risk compared to Stormy because it has a greater utilization rate on its assets. If, like in Spring 2020, the tide turns on the economy and tourist demand for cruise ship holidays dries up by say, 20%, then Sunny may still be afloat. But Stormy would barely break-even and may be even underwater, profitability-wise.
The judgement comes in on the application of the rule of thumb. For example, if the rule of thumb range of metrics for cruise ships was 2x – 4x income, then Sunny Sailings would get 4x income on its sale and Stormy Seas would only get 2x income. This is a judgement call, based on the analysis of the economic environment, the relevant industry and the relative financial performance of the two companies.
Which company would you buy?