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What Is Rule-of-Thumb Worth?

What Is Rule-of-Thumb Worth?

In the litigation setting, whether it be divorce, shareholder disputes, or other sale of a business interest, it is common for the parties to want to spare the expense of a professional valuation expert and instead opt for a simple calculation, using an industry rule-of-thumb. A rule-of-thumb value can often be utilized by valuation experts in conjunction with other methodologies as a sanity check; however, unless the rule-of-thumb is supported with other valuation methods, it should not be relied upon as an indication of value as there are significant limitations which could lead to a material distortion of value.

What is a Rule-of-thumb?

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.

Why are Rules of Thumb Unreliable?

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.

What is Average?

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:

  • Profitability – a business which is more profitable will generally net a higher selling price than others in the same industry
  • Hours – a business which is only open 40 hours a week could sell at a higher price than one which must be open 60 hours per week to generate the same revenues
  • Location – depending on the industry, business location can result in either a higher or lower selling price that others in the industry
  • Financial history – a business with revenues that are consistently increasing will generally sell for a higher price than those which are declining

What is the Economic Reality of the Situation?

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:

  • Stock and asset sales are different – in an asset sale, certain assets or liabilities can be withheld and not included in the sale.
  • Contingencies – sale terms can include contingencies, such as future additional payments based on revenue retention.
  • Payment terms – structured payouts may not bear interest or may include interest at below market rates, thereby distorting the true economic price of the transaction.
  • Continuation of employment by seller – some sales may include the seller to continue employment for a specified period of time with all compensation considered to be included in the sales price

When to Use the Rule-of-Thumb?

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.

[i] http://www.merriam-webster.com/dictionary/rule%20of%20thumb

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