(Originally Posted October 8, 2019)
In limited circ*mstances, the rule of thumb technique can be effective – it enables stakeholders to quickly and cost-efficiently calculate a rough value of their business. However, when dealing in situations that require a more technical and precise value, such as transactions, estate planning, and litigation, relying on rules of thumb instead of accepted valuation techniques may materially over or undervalue business interests.
What is a Rule of Thumb Valuation Approach?
Merriam-Webster dictionary defines arule of thumbas:
- A method of procedure based on experience and common sense.
- A general principal regarded as roughly correct but not intended to be scientifically accurate.
For valuation purposes, a rule of thumb involves applying an industry-specific multiple to an economic benefit, such as business revenue or discretionary cash flow. For example:
- A businesses’ goodwill may be worth 2.0x discretionary cash flow; or
- An accounting practice’s value may be worth 1.0x to 1.25x annual revenue plus work-in-process inventory(1).
These rules of thumb are traditionally derived from a combination of experience, observations, hearsay, and real-world market transactions.
The Problem with Rules of Thumb
Consider a Toronto-based business owner who sells a minority interest of their business for the implied price of 5x Earnings Before Interest and Taxes (“EBIT”). During an informal discussion at a conference two years later, this multiple is discussed with another industry participant who operates a similar, but less profitable, business in a small town in Quebec. Relying on this information, the Quebec operator decides to price their business using the same 5x EBIT multiple.
The only commonality between the two businesses is that they operate in the same industry. A proper valuation approach may consider the company’s size, underlying assets, income or cash flow, economic and industry conditions, competitive advantages, and other unique factors when determining the appropriate value. The rule of thumb method, on the other hand, considers none of these factors.
Rules of Thumb in Formal Valuation Reports
In certain circ*mstances, Chartered Business Valuators (“CBV”) may apply rules of thumb to formal business valuations. However, unlike in our example above, CBVs traditionally use an earnings or cash flow-based approach as a primary valuation methodology, and then consider rules of thumb as a secondary check.
If the conclusions from the rule of thumb test arenotconsistent with the CBV’s expectations, this may indicate that further understanding and analysis is required, or that a revision to the primary valuation methodology may be needed. Rules of thumbs are however, rarely used as the primary method of calculation.
Conclusion
Rules of thumb offers a unique valuation tool to business stakeholders – the opportunity to quickly and cost-efficiently calculate a ballpark value of their enterprise. And while useful in limited contexts, stakeholders should be cautious to avoid undo reliance on these methods in place of commonly accepted valuation techniques.
As always, it is important to understand the inner workings, and limitations, of any valuation approach used.
If you have found yourself in a situation that requires a formal valuation report,give the experts at Davis Martindale a call. We’d love to work with you.
You may also be interested in Part 2 in this series:Application of Rules of Thumb in Court
