Many times business owners and advisors rely on “Rules Of Thumb” instead of a professional valuation or marketability assessment. The parties involved hope to avoid the expense and trouble of a professional valuation or marketability assessment by subscribing to a simple value formula or rule of thumb common to their business type.  This type of methodology implicitly assumes that determining the value of a business is uncomplicated and can be reduced down to a simple formula.

While one can use a rule of thumb to develop a very rough estimate of value and provide a weak form of market comparison for a small, closely held business or professional practice, relying solely on this type of approach can cause serious problems.  Though a rule of thumb is admittedly easy to use, the value it indicates should never be considered valid unless backed up with other more detailed valuation methods specific to the particular business that is subject to appraisal.

When the Rules Don’t Apply
In addition to oversimplification and potential for abuse, a large problem with rule of thumb formulas is that they are derived statistically from the sale of many businesses of the same type.  For example, suppose an organization compiles statistics on 100 auto dealerships.  The organization then averages all 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 that relates a dealership’s value directly to its gross revenues.

While it is fair to assume that a dealership’s gross revenues is positively correlated with total firm value, the rule of thumb method inaccurately assumes that the relationship is relatively constant from one dealership to the next.  A problem arises when one dealership may have sold for twice one year’s gross revenue while another may have only sold for half. This problem illustrates that rule of thumb formulas may be accurate for businesses whose performance results are about average, but not for those who vary far from the average. To apply a rule of thumb to a business that varies significantly from the average is not appropriate as it can grossly misstate value.

A greater problem arises when a business owner uses a rule of thumb that he or she has heard of through the grapevine.  For instance, suppose Joe Jones, a business owner, learns from an associate that Sue Smith, Joe’s competitor, sold her business for three times annual earnings.  However, Joe does not know what type of earnings was used in calculating Sue’s multiple.  Many possibilities exist, including:

• Earnings before tax;
• Earnings after tax;
• Owner’s discretionary cash flow; and
• Earnings before or after subtracting the owner’s compensation.

Joe also probably does not have specific information on the terms of Sue’s deal.  Were the terms of the transaction all cash or 10% down plus a personal note to the seller with no interest?  By utilizing the rule of thumb, Joe believes the “three times earnings” estimate without having answers to these and other important questions.  He also assumes that Sue’s business actually sold for the price he heard of through the grapevine.  In reality, Sue might have under- or over-reported the amount she received for the business, or the specific details of the transaction may have been left out when the story was retold.

For these and other reasons, using a rule of thumb may lead Joe to a highly erroneous estimate of the value of his business.  This problem is compounded when the value is utilized for property settlement purposes in a divorce proceeding.

Adjusting the Rules
Rules of thumb are supposed to be market-derived units of comparison.  The “multiple of” percentage contained in a given formula is an expression of the relationship between gross purchase price and some indicator of the operating results 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 reflect differences in risk, profitability, capital structure and lease terms. The adjustments produce a multiple, usually related to earnings, cash flow or equity, which the valuator then applies to the subject entity in order to derive a meaningful estimate of value.

Get Professional Advice
At best, a rule of thumb is merely a check on a properly derived value and should never be relied upon solely in valuing a business.  As a “back of an envelope” estimate of value, a rule of thumb may give you a rough idea.  However, in a divorce context, a business’s value should be determined through a more rigorous analysis and, at a minimum, should be checked against value indications derived from other valuation approaches. 

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

Business owners tend to be optimistic in placing a higher value on their own company then what the market will actually bare out.  Thus, business owners as well as advisors should use rule of thumb valuations for informational purposes only.  When using this information for estate, business or for merger and acquisition planning, the swings in what the actual market value is and what was generated by using a rule of thumb valuation can become catastrophic, depending of what expectations are being managed by said value.