Valuation experts frequently encounter scenarios where a subject company doesn’t fit neatly into a single North American Industry Classification System (NAICS) code. Instead, the business spans multiple industries, complicating the benchmarking and valuation process. Properly combining multiple NAICS codes to produce meaningful results requires thoughtful methodology, informed judgment, and careful application of relevant industry data, such as the Risk Management Association (RMA) Annual Statement Studies. Of course, the most important point in this article is that the expert is responsible for the methods and application of the data in any given facts and circumstances, but a strategy to deal with this issue can be helpful.

Avoiding Common Pitfalls

A common mistake occurs when valuators evenly average benchmarks across multiple NAICS codes without considering the relative representation of each group. Commonly, this is known as averaging the averages. For instance, suppose one industry classification from the RMA data includes financial data from 100 companies, while another classification includes only 30 companies. Assigning a simple 50/50, or average of the averages, weighting would misrepresent the data:

• 50% × 30 companies (potentially overweighted)
• 50% × 100 companies (potentially underweighted)

An uneven distribution of underlying data can skew results and lead to inaccurate conclusions. The valuator must assess whether sample sizes should be factored into the analysis in each specific case.

Recommended Approaches to Properly Weight NAICS Codes

Two approaches should be considered when combining multiple NAICS codes:

1. Weighting by Sample Size: Weighting benchmark data by sample size ensures proportional representation of each industry. Using the above example:

• Industry A: 100 companies
• Industry B: 30 companies

Using the proportional weighting:

• Industry A: 100 / (100+30) = 77%
• Industry B: 30 / (100+30) = 23%

Applying these proportions produces balanced, representative valuation benchmarks, thus improving reliability.

2. Weighting by Subject Company Revenue Composition: Alternatively, weighting can reflect the actual financial operations of the subject company. Suppose the subject company generates:

• 60% revenue from activities within NAICS code A
• 40% revenue from activities within NAICS code B

Applying valuation multiples or benchmarks proportionately to these revenue streams enhances accuracy and context-specific relevance.

Contextual and Practical Considerations

It’s essential to understand that no single weighting method suits every benchmarking metric. The chosen approach often depends on the targeted valuation metric:  For example:

• Gross Profit Margins: Sample-size weighted benchmarks might yield a reliable benchmark for the subject company.
• Officer Compensation and Expense Ratios: Revenue-based weighting might better reflect the company’s specific cost structures and operational nuances.

Using RMA Annual Statement Studies effectively involves acknowledging these subtleties. Valuators must apply industry benchmarks contextually, aligning their analysis with the facts and circumstances unique to each valuation engagement. In every case, the expert’s role is to align the data to the subject company and explain why and how that alignment is appropriate.

Documenting Your Approach

Clearly documenting your chosen weighting methodology is critical. The valuation report should explain:

• Why multiple NAICS codes were selected.
• The rationale for weighting by sample size, revenue composition, or another method.
• How these choices specifically align with the subject company’s characteristics.

The reasoning, the logic, and the conclusions drawn are what drive the credibility of the report and the reliance on the conclusions drawn therein.

Conclusion

Combining multiple NAICS codes correctly may demand more than straightforward mathematical averaging—it requires careful evaluation and nuanced judgment. By thoughtfully applying sample-size, revenue-based weightings, or other methods and clearly documenting your rationale, you will produce more credible, accurate opinions, reinforcing your reputation as a skilled and thoughtful valuation professional.