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What Are Rules of Thumb Worth?

Although a business valuation rule of thumb is easy to use, the value it indicates should never be considered valid unless it is backed up with more detailed valuation methods specific to the business and industry

It is not uncommon in a divorce, the sale of a business, or litigation, for the parties to try to avoid the expense and effort of a professional business valuation, opting instead to use a simple value formula or “rule of thumb” common to their type of business. This type of methodology erroneously implies that determining a businesses value can’t be all that complicated and can be reduced to a simple formula.

Business owners looking to sell their company are undertaking a transaction that is usually crucial to their net worth. If the business is overpriced, the owner could lose qualified buyers; if the business is underpriced, the owner will not receive full value. Although a rule of thumb is admittedly easy to use, the value it indicates should never be considered valid unless it is backed up with other, more detailed valuation methods specific to the particular business and industry.

A rule of thumb can be utilized to develop a very rough value and provide a weak form of market comparison for a small business, but relying solely on this approach can cause serious problems.

When the Rules Don’t Apply

In addition to oversimplification and potential for abuse, the main problem with rule-of-thumb formulas is that they are derived statistically from the sales of many businesses of the same type.

For example, an organization may compile statistics on a hundred sales of auto dealerships. The organization then averages all of the selling prices and calculates that the average auto dealership sold for 100% of one year’s gross revenue. This creates a rule of thumb for valuing auto dealerships.

The problem is that one dealership may have sold for twice one year’s gross while another may have sold for half of one year’s gross. Thus, rule-of-thumb formulas may be reasonable for businesses whose performances are about average but not for businesses that don’t fit the mold. To apply a rule of thumb to a business that varies significantly from the average is not appropriate.

An even bigger problem exists when a business owner uses a rule of thumb that he or she heard through the grapevine. For instance, suppose Joe Jones, a business owner, hears from an associate that Sue Smith, Joe’s competitor, sold her business for three times earnings. Joe doesn’t know what type of earnings Sue used. Was it earnings before tax? Earnings after tax? Owner’s discretionary cash flow? Earnings before or after subtracting the owner’s compensation?

Joe probably also doesn’t know what the terms of Sue’s deal were. Was it a cash deal, or did Sue receive 10% down and agree to take a no-interest personal note? Joe believes the “three times earnings” rule of thumb without asking these questions. He also assumes that Sue’s business actually sold for the price he heard through the grapevine. But Sue might have under- or over-reported the amount she received for the business, or the specific details of the transaction may have been lost when the story was retold.

For these and other reasons, using the rule of thumb he heard about will almost certainly lead Joe to a highly erroneous estimate of the value of his business.

Adjusting the Rules

Rules of thumb are supposed to be market-derived units of comparison. The multiple or percentage contained in the formula is an expression of the relationship between gross purchase price and some indicator of the operating results or financial position of a business. The use of a rule of thumb in the valuation of a closely held entity is actually a variation of the market comparison approach, which attempts to establish value via direct comparison with similar sales in the marketplace.

The use of direct market comparison depends on the availability of sales of reasonably comparable businesses in a free and active marketplace. A valuator then calculates adjustments for differences between the acquired businesses and the subject entity. These adjustments include differences in risk, profitability, capital structure, and lease terms. The adjustments produce a multiple (usually related to earnings, cash flow or equity) that the valuator applies to the subject entity to derive an expression of value.

The difference between using rules of thumb and the direct market comparison method is that, with the direct market comparison, the valuator has access to the details of the transactions that are used to determine the multiples. Because of this, the valuator can determine which transactions are relevant or involve companies that are more comparable to the subject company. In this manner, the valuator can make the necessary adjustments in order to come up with multiples that are more directly applicable to the subject company.

Get Professional Advice

At best, a rule of thumb is merely a sanity or reasonableness check on a properly derived value and can never be relied on alone. If a party wants to know the value of the business just for curiosity’s sake, a rule of thumb may suffice. But if he or she needs to know the value of the business for use in a potential transaction, to set up a buy-sell agreement, to develop an exit strategy, or any other reason (including shareholder litigation and marital dissolution) that has economic ramifications, it is beneficial to get professional valuation advice.

This argument is further supported by the American Society of Appraisers (ASA) Business Valuation Standard relating to rules of thumb. It states:

“Rules of thumb may provide insight on the value of a business, business ownership interest, or security. However, value indications derived from the use of rules of thumb should not be given substantial weight unless they are supported by other valuation methods and it can be established that knowledgeable buyers and sellers place substantial reliance on them.”