Are Rules of Thumb an Adequate Way to Value a Business?
January 17, 2019 | Jeremy Green
Let me begin by answering that question. No! Now it is my responsibility to explain why. While “Rules of Thumb” typically derive from industry trends and comparable company research, they miss out on vital factors that must be considered when determining a reasonable value for a business or ownership share.
First, let’s start with an example of similar businesses in the same industry and how relying solely on a Rule of Thumb could be problematic. Ice Cream Store A and Ice Cream Store B are being valued simultaneously for a potential sale. The two ice cream stores have similar revenues, expenses and gross profit. From a financial perspective, they are nearly identical.
Hypothetically, let’s say the Rule of Thumb for the average value of an Ice Cream Store is around 100% of current years revenue. This Rule of Thumb is based on the national average sale price vs. annual revenue. Using the above Rule of Thumb for ice cream stores, Store A and Store B would calculate out to a similar value since they have similar annual revenue. Right? Let’s see…
Now, what we haven’t considered in our valuation of the two ice cream stores is that across the street from Ice Cream Store A, a Dairy Queen® and an Orange Leaf® were just opened within the last 6 months. Additionally, Ice Cream Store A is located in Fargo, N.D. whereas Ice Cream Store B is located in Phoenix, Ariz. Hopefully, it is becoming clear that if we only relied on the Rule of Thumb, we would overlook the fact that Ice Cream Store A most likely could be worth less due to risks associated with a recent increase in direct competition. Additionally, the seasonality and dependency of the weather of Ice Cream Store A’s location in North Dakota warrant an increase in risk to its cash flow.
Rules of Thumb are best described as a shortcut version of the Market Approach, which relies on “market multiples” of sales or earnings for what comparable businesses sold for. In our example above, our market multiple was one times annual revenue (100% of revenue), which calculated the value of the two Ice Cream Stores. Good valuation analysts know all three approaches (Asset, Income and Market Approaches) should be considered when performing a business valuation engagement. Good valuation analysts are also aware of the Rules of Thumb relevant to businesses they are engaged to value. However, they are cautious in using them. Rules of Thumb are considered by some valuation analysts to be useful in a last resort situation. Even then, it is not recommended to solely rely on the use of a Rule of Thumb in determining the value of a business or ownership share due to its neglect of other vital factors as illustrated above. Additionally, solely relying on a Rule of Thumb in a business valuation will most likely not withstand the scrutiny of the IRS for tax purposes.
Business valuation is not an exact science. It’s based on judgment, experience and relevant information. It’s important to select a well-qualified professional with extensive experience in evaluating all types of organizations. When facing a potential buyout or other change in business ownership, you need a professional who is qualified and accredited to perform business valuations. As a full-service CPA Firm with multiple accredited business appraisers on staff who perform valuations on a full-time basis, TDT CPAs and Advisors can assist you with those challenges related to Business Valuation and also provide services related to your accounting, tax and assurance needs as well.