There are many tales behind the origin of the phrase “rule of thumb”, some of which are more realistic than others. The story that is the most widely accepted is that woodworkers used to use the width of their thumb, rather than rulers, for quick measurements. Regardless of how the phrase got its start, a rule of thumb is considered to be an imprecise, yet convenient measurement standard. Relying solely on a rule of thumb to value a business, however, can lead to unreliable valuation conclusions.
Rules of thumb used for valuing businesses are often industry specific and are stated as multiples of revenues, EBITDA, net income, or some other metric. Rules of thumb often have their foundation in industry hearsay mixed with multiples derived from actual transactions for similar companies (although which transactions and companies are anybody’s guess). Considering the unprecedented economic environment today, older rules of thumb may no longer be reliable regardless of their predictive power of value in previous years. In addition, rules of thumb often do not take into consideration the profitability of the company being valued, the industry outlook, the depth of management, and many other factors that are considered when a full business valuation is being prepared. Finally, nearly every professional valuation association (if not all of them), does not allow for a rule of thumb to be used as the primary valuation methodology. As a result, relying on a rule of thumb alone to value a business will result in a value that will not be defensible before the IRS or in litigious situations.
Although using a rule of thumb is frowned upon as a primary valuation method, rules of thumb may still be beneficial to business owners and valuation analysts. For business owners, rules of thumb offer quick and dirty estimates of value that can be useful for high-level strategic planning. For valuation analysts, rules of thumb can be used a reasonableness check for the value of a company determined by asset, income, and market-based approaches.
The important thing to remember is that a rule of thumb is a great shortcut for a business owner to use to determine the value of his or her company for strategic planning. If a defensible value is required, however, a rule of thumb should be used as no more than a cross-check against the more traditional valuation methods, such as the capitalization of earnings/cash flow method, discounted earnings/cash flow method or private company transaction method.
Looking for business valuation assistance in Cleveland or Akron? Contract our Business Valuation Services group at 440-449-6800 for more information.