It’s a well known fact that for almost every different type of business there is an associated rule of
thumb for valuing it. Using one of the quickest, easiest and most cost effective ways to value your
company, however, might end up coming back to bite you in the end.
Because they are typically based on industry averages, it is not uncommon for rules of thumb to fail to capture the specific value drivers of your company. Typically, rules of thumb provide an estimate of value that are to be used to gain an understanding of how much you might be able to obtain upon sale of your company. However, these rules of thumb have been known to show up on the negotiation table as well. As beneficial as a rule of thumb might be, there is no substitution for a comprehensive, formal valuation.
What is a rule of thumb?
The International Glossary of Business Valuation Terms defines “rule of thumb” as “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.”
In most cases, rules of thumb are expressed as a multiple of revenues or some form of earnings or cash flow. They may also be based on multiples of assets or units of capacity or activity. For example, one rule-for-thumb for valuing a motel is $20,000 per room.
So where do rules of thumb come from? Many rules of thumb are derived from actual sales of
companies. These sales are typically reported by professionals who are involved in brokering the
deal. In addition to brokers, many rules of thumb come from industry consultants, trade associations,
publications and word of mouth. The most useful rules of thumb are those that are specific to your
industry and geographic location.
What are some pitfalls?
A rule of thumb is a variation to the market approach to valuation. The market approach to valuation
derives value based upon multiples from transactions involving businesses with adjustments made to reflect unique aspects of the subject company. It is at this point where relying solely on a rule of thumb could potentially derail your estimate of value. The key to an accurate valuation is access to information to determine how comparable other company’s transactions are relative to the subject company and identify any appropriate adjustments.
One glaring flaw with utilizing rules of thumb is the fact that they are based on average multiples from company transactions that may or may not be comparable to the subject company. In addition, they are often based on subjective judgment or word of mouth rather than a verifiable source.
Even if a rule of thumb is based on a credible source with verifiable data, it is nearly impossible –
without access to the specific details of the underlying companies and transaction – to determine if the rule of thumb is even applicable to the subject company. For example, a common rule of thumb for valuing full-service restaurants is 30% of gross revenue. But prices in actual transactions range from well under 20% to well over 100% of gross revenue.
So why such a wide range in value? The answer to this question comes in the form of unique aspects associated with the subject company. These factors can include revenues, such as gross profits, lease and other expenses, cash flow, growth, location, competition, management strength, and risk. A rule of thumb might yield a value that is near the industry average in these specific areas; but for those companies who deviate from the norm, rules of thumb are unreliable indicators of value.
Also, rules of thumb often fail to account for transaction terms. For example, do transactions involve
seller financing or cash purchases? Were the transactions stock sales or asset sales? Was real estate or inventory included in the transaction? Should debt be included or excluded in the value? All of these items, as well as many others, can have a significant impact on value, but rules of thumb typically fail to provide enough detail to answer these questions.
Finally, the individual applying the rule of thumb needs to understand the defined terms. If a business is valuated at four times earnings, for example, the resulting value can vary dramatically based upon the definition of “earnings”. Does this mean after-tax earnings? Earnings before interest and taxes (EBIT)? Owner’s discretionary cash flow?
Rule of thumb in action
Let’s consider an example of the weakness of many rules of thumb. Company A and Company B are
local hardware stores. One rule of thumb for a hardware store is three times earnings before interest
and taxes (EBIT). Companies A and B each have $300,000 in EBIT in 2012, so each would be valued at $900,000 under this rule of thumb.
Let’s suppose, however, that Company A’s EBIT was $50,000 in 2010 and $175,000 in 2011. Company B, on the other hand earned $750,000 in 2010 and $500,000 in 2011. Though the rule of thumb values each company equally, an informed buyer would place more emphasis on Company A, especially if there was reason to believe the historic trend and growth pattern was going to continue into the future.
Proceed with caution
In instances that require accurate valuation – such as business sales, tax planning or litigation – rules of thumb should not be substituted for a professional valuation using generally accepted methods. Though they might be appropriate for developing a rough estimate of value, to gain a better understanding of the aspects that make your company unique, a formal valuation by a local professional should be considered.
(Matt Stelzman is an accredited valuation analyst and certified forensic financial analysts with Henderson Hutcherson & McCullough where he works in the Specialized Services Group providing business valuation and litigation support services.)