Sensible Rules for Using Rules of Thumb

By: John T. Sweeney, Senior Investment Banker, and James A. Gravitt, CPA, CBA, ABV, CFE 

The term “Rule of Thumb” (the abbreviation “ROT” is used throughout this article) is thought to have originated with wood workers who used the width of their thumbs as a standard measure. That practice gave us the modern colloquialism, meaning “an imprecise yet reliable and convenient standard.” In many ways, this is an apt description for the more popular shortcuts used today for valuing businesses. Given their advantages and disadvantages, this article asks what role ROTs can play in business valuation and in buying and selling businesses.  
 The International Glossary of Business Valuation Terms, a joint publication of the American Institute of Certified Public Accountants, the American Society of Appraisers, the Canadian Institute of Chartered Business Valuators, the National Association of Certified Valuation Analysts, and the Institute of Business Appraisers, defines “Rule of Thumb” this way:
Rule of Thumb—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.”
ROTs typically fall into one of five categories:
  • Multiple of revenues
  • Multiple of some form of earnings or cash flow
  • Multiple of assets or of “book value”
  • Multiple of a unit of activity or capacity (i.e. restaurant tables, hospital beds, subscribers, etc.)
  • Combinations of the above (such as a multiple of earnings that adds the value of certain assets)
According to business appraisal organizations, ROTs are not acceptable business valuation methods. Their use as such is contrary to the organizations’ professional standards, as well as established business valuation guidance such as IRS Revenue Ruling 59-60. For example, the American Society of Appraisers’ Business Valuation Standard relating to ROTs states:
“ROTs may provide insight on the value of a business, business ownership interest, or security. However, value indications derived from the use of ROTs 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.”
Sources of ROTs include business brokers, industry consultants, and publications. One of the earliest publications was the Handbook of Business Valuation Formulas and Rules of Thumb (“HBVFRT”), published in 1993 and authored by Glenn Desmond and John Marcello. An annual publication, Business Reference Guide, published by Business Brokerage Press, lists ROTs for almost 700 types of businesses.
In HBVFRT, Glen Desmond makes the following observation: “There is no single formula that will work for every business. Formula multipliers offer ease of calculation, but they also obscure details. This can be misleading. Net revenue multipliers are particularly troublesome because they are blind to the business’s expenses and profit history. It is easy to see how two businesses in any given industry group might have the same annual net revenue, yet show very different cash flows. A proper valuation will go beyond formulas and include a full financial analysis whenever possible.”
Despite such admonitions concerning their use, the popularity and sheer numbers of ROTs seems to be increasing, particularly among those who are not business valuation professionals. Many buyers and sellers do seem to use ROTs in place of more formal business valuation methods. So what is their place in the world of business valuation and business transactions?
ROTs have many advantages, including:
  • Quick shorthand during preliminary discussions, and in negotiation.
  • Ease of use (at least on the surface, see discussion below).
  • Inexpensive; can be done in house versus an external valuation project.
  • Provides a general guideline or range of value.
  • Easy to understand and follow the “link” to value.
  • Expresses value in easy to understand vernacular used by market participants.
  • May work well for “cookie cutter” businesses that are relatively similar.
  • ROTs are often based on industry expertise.
  • ROTs may be especially useful for small businesses, where the cost and time commitment makes a full valuation impractical.
What are some possible disadvantages of ROTs?  
  • Little consideration of the many variables affecting value. For example, a business valuation considers both external factors (economy, industry, competition) and internal factors (customer concentration, management strength, adequacy of facilities, etc.)
  • Uncertainty as to what parts of the business should be included in the ROT. For example, should assets such as real estate and equipment be added? What about inventory and accounts receivable? Are current liabilities and long-term debt included or excluded?
  • Are companion agreements such as non-compete contracts included in the ROT?
  • Potentially misleading results. The ROT may be used for important decisions that should be submitted for more complete analysis.
  • Confusing language. For example, the term “earnings” can refer to income after taxes, pre-tax earnings, earnings before owner compensation, earnings before interest expense, etc.
  • Does the “answer” derived from a ROT represent a price for the company’s stock or for its assets?
  • Normalizing adjustments such as eliminating non-recurring sales or expenses may or may not be considered in the ROT.
  • Lacking adequate documentation, ROTs may be inappropriate for use in some situations, for example to serve as the basis for estate planning or charitable gifting.
  • ROTs are not “data driven” in the same way that value indicators based on comparative private company transaction data or guideline public company data are. The multiples may be based on insight and personal experience rather than on actual, timely data.
  • ROTs may produce a wide range of different values for the same business. For example, the 2011 edition of the above mentioned Business Reference Guide lists the following ROTs for dental practices:
1.       60 – 65% of annual sales plus inventory
2.      70% of collections, excluding accounts receivable, including equipment
3.      2.5 times SDE (seller’s discretionary earnings) plus inventory
4.      1.5 – 2.0 times SDE, add fixtures, equipment and inventory, may require earn out
5.       2.5 times EBIT
6.      3.0 – 3.5 times EBITDA
 
One can easily note that applying all of the above rules could result in many different values. Which ones are reliable, and why?
  • The rule may ignore critical drivers such as whether the business generates free cash flow and whether its growth trends are positive. Many business appraisers consider analysis of cash flow and growth as two of the most important factors in valuing a business.
  • The ROT may be out of date and inconsistent with recent trends in a given industry.
Some conclusions
Given their advantages and disadvantages, what role can ROTs play in business valuation and in buying and selling businesses? We conclude that ROTs can serve a useful purpose, as they often are rooted in real-world metrics. In fact, if used often enough, they can become a de facto standard, as they become somewhat of a self-fulfilling prophecy. From a business valuation professional’s standpoint, they can also provide a useful “reality check” on the concluded value. If the appraised value is significantly different from the applied ROT, the valuation professional may seek further validation of his/her work.
ROTs are seldom “wrong,” but they often are misapplied and can be misinforming. They thus represent one more tool for the appraiser to use to get to the “right” answer in business valuation. For the business owner or transaction participant, ROTs present the opportunity to initiate the discussion and buy-sell process via a useful “starting point” for business value.