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 cant 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 Dont 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 years gross revenue. This creates a rule of thumb for valuing auto
The problem is that one dealership may have sold
for twice one years gross while another may have sold for half of one years
gross. Thus, rule-of-thumb formulas may be reasonable for businesses whose
performances are about average but not for businesses that dont 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,
Joes competitor, sold her business for three times earnings. Joe doesnt know
what type of earnings Sue used. Was it earnings before tax? Earnings after tax?
Owners discretionary cash flow? Earnings before or after subtracting the
Joe probably also doesnt know what the terms of
Sues 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 Sues 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
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
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
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 curiositys
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.