A rule-of-thumb is defined as “a general principle regarded as roughly correct but not intended to be scientifically accurate.”[i] In business valuation, rule-of-thumb formulas are derived from market data related to sales of businesses within a particular industry. Data is compiled relative to each company that was sold and a rule-of-thumb is created, based upon the average of all of the transactions. Typically the resulting rule-of-thumb formulas are a multiple of revenues or earnings.
Rule-of-thumb formulas utilize averages that are supported by market data but do not provide enough underlying information to adjust the rule-of-thumb formula for the subject company’s unique attributes.
Rule-of-thumb sources generally do not include the underlying data relative to each business included in the formula; therefore, it is impossible to determine whether a subject company is “same or similar” to those included in the rule of thumb data. Although a business may be in the same industry, there are significant differences that can make them not comparable and require adjustment to the formula:
Terms of the deal are what dictate the price of the deal. Rules-of-thumb are merely averages of data from numerous sales transactions, regardless of the distinct characteristics inherent in each, and include reported sales prices which may or may not represent the present, cash-equivalent value of the transaction. There are significant variables in the underlying market data which could create skewed results if not taken into consideration in conjunction with the valuation of the subject company:
Any time that the market suggests that an industry is valued in accordance with a particular rule-of-thumb, the valuation expert should certainly consider the data in conjunction with other valuation methodologies. However, if used incorrectly as a sole method of valuation, without regard for the particulars of the subject company, a rule-of-thumb valuation can be extremely dangerous.
The information contained herein is not necessarily all-inclusive, does not constitute legal or any other advice, and should not be relied upon without first consulting with appropriate qualified professionals for your plan’s individual facts and circumstances.