The following is a short excerpt from Estimating Value Based on Recurring Revenue by our VP of Business Valuation Services, Ryan Grau, CVA, CBA.
It is important to understand the difference between an adjusted pricing multiple based on the specific characteristics of the business being valued versus a “rule of thumb.” A rule of thumb for the financial services industry is that businesses sell for two-times gross recurring revenue and one-times non-recurring revenue, or that they are worth five-times Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA). Often sellers approach us asking if the offer they have received based on a rule of thumb is sufficient or fair. This question cannot reasonably be answered without understanding the revenue characteristics of the practice.
Rules of thumb are not based on empirical evidence and have not been examined or tested to determine their validity. A rule of thumb is merely a means of estimating value based on a rough and ready practical rule, not based on science or exact measurement. Other definitions include “[a] theoretical market-derived unit [ ] of comparison”¹ and “a mathematical formula developed from the relationship between price and certain variables based on experience, observation, hearsay or a combination of these; usually industry specific.”² A rule of thumb is therefore used as a reasonability check for other valuation methods that are not tied directly to observed market transactions. It should never be used as a stand-alone method for valuing a business.
An adjusted pricing multiple is the result of a professional appraiser’s many hours of market research and analysis of the subject practice as it compares to observed prices in the market. Arriving at an adjusted pricing multiple requires an understanding of how buyers in the marketplace perceive value and what those key value drivers are. For financial services practices, this key value driver is recurring revenue. It is the difference between a practice selling for 0.27 times annual gross revenue and 2.84 times annual gross revenue.
Download the full text of Estimating Value Based on Recurring Revenue to access further expert analysis of revenue as a key value driver and our most recent data for average multiples based on revenue source.