Industry NAICS Codes explained
Business industries are classified under the North American Industry Classification System (NAICS). The NAICS allows for detailed categorization of businesses into industries.
At its most detailed, NAICS uses six digit codes that signify the economic sector, subsector. Selecting a precise NAICS code is critical in business valuation and benchmarking exercises.
How industry selection impacts business valuation
Under Market Approaches to estimating business valuation, the industry NAICS code informs which valuation multiples can be applied to a business's earnings or revenue to estimate valuation.
What is a valuation multiple?
Valuation multiples are ratios between market value and financial benchmarks like earnings and revenue used to estimate business valuation.
- When businesses are sold, the transactions can be used as reference to estimate the value of comparable businesses within that industry
- To make these reference transactions more practical during valuation exercises, ratios between market value and financial benchmarks like earnings and revenue are calculated and aggregated across these historic transactions
- This creates a set of "valuation multiples" that are specific to each industry
The two most common valuation multiples
The two most common valuation multiples are EBITDA and revenue multiples.
- EBITDA Multiple: A ratio of the market value (Enterprise Value) to earnings
- Revenue Multiple: A ratio of the market value (Enterprise Value) to revenue
For private small and mid-sized businesses (SMBs) that are well established, EBITDA valuation multiples tend to be relied on more heavily. For pre-revenue or very early-stage companies, revenue multiples become more relevant.
Identifying valuation multiples
Under Market Approach methods to estimating business value, an EBITDA or Revenue multiple is identified by:
- Finding a set of the most comparable historic transactions to the business being valued
- Comparing the business to that set to determine where they are similar and different
- Estimating a reasonable multiple for the business being valued based on this comparison
Multiples selection exercises start by searching for the most comparable historic transactions to reference. Ideally this search yields 5 to 10 highly comparable transactions.
In general, comparability is determined with these criteria:
- Industry. Transactions within the same 6-digit NAICS industry code are considered more comparable while transactions within the same 2-digit NAICS sector code are considered less comparable.
- Transaction recency. The more recent a transaction is, the stronger it serves as a reference point
- Revenue, EBITDA, and margin of business that sold. Ideally the businesses in the transaction set have a revenue, earnings, and margin within a reasonable range of the business being valued. The closer these metrics are to the business being valued, the more comparable the transaction is considered.
Highly comparable transactions are hard to find for some businesses. In this case, a wider set of moderately comparable transactions can be used to examine the trends of an industry or sector more broadly.
It’s always important to compare market approach estimates of business value to income approaches as anchoring points since historic transaction data can be sparse or statistically noisy for some business types.
💡 RISR references best-in-class historic transaction data covering 800 industries to find the most comparable transactions for each business. A custom reference set of historic transactions is built based on how recent each transaction is, the industry of the business, and how similar the business that sold is in terms of revenue, earnings, and margin. This ensures the most relevant EBITDA and revenue multiples are identified using the best data available.
Applying valuation multiples
To apply these multiples to estimate Enterprise Value, simply multiply them by the related financial benchmark
- Example estimate of Enterprise Value using a 4x EBITDA Multiple: ($275k X 4.0) = $1,100,000
- Example estimate of Enterprise Value using a 0.8 Revenue Multiple: ($1.2M X 0.8) = $960,000
In this case, the Market Approach using valuation multiples output a range of Enterprise Value between $960K and $1.1M. It's important to note that for the purposes of financial planning with business owners, these Enterprise Value estimates should be converted to Equity Value to better reflect what the value of the owner's equity.
Selecting NAICS Codes for valuation estimates
Selecting industry codes is a nuanced process since the system used to classify industry is robust and detailed.
Follow these practices to help clients identify the industry:
1) During discovery, use the business's website to understand its primary products and services
- It's important to gather context around what the client's business does during discovery
- Try to understand what product or service is driving the majority of its revenue
2) Use search and AI answer engines to identify which 6-digit NAICS codes may be relevant
- Paste descriptions of their primary products / services into tools like Google and ChatGPT
- Ask which 6-digit NAICS code is most relevant and why
3) Reference business tax returns if available
- An industry description generally appears on most federal business income tax returns
- Note, many businesses misreport or leave the description too broad in tax forms
- It's important that this be scrutinized during a valuation exercise to ensure precision
- Review this code and compare it to your own references listed above with the client and their team