As a business valuation expert, if I had a buck for every time a professional adviser or business owner asked me about a Rule of Thumb (ROT) value for a particular business, I would be fishing right now (and you would not be reading this blog). The truth is that I have never received even a single dollar for that information and I hope that tells you the value of a ROT as a business appraisal method.
At best, a ROT is a rough estimate. While rough may appease a mild curiosity today, rough will equate to actual dollars in the future. Take a moment to think this through to its conclusion. There are only so many reasons why you need to know the value of a business. For example, it might be for a sale, transfer to the next generation, buy/sell agreement, insurance, retirement or tax planning. Any decisions you make in these areas based on the value of your business hold significant real dollar value for you in the future. Other then “bragging rights,” you ultimately have only serious reasons you need to know, and even fractions off can be costly.
When the day comes those dollars are real, you are likely to find that your original estimate based on ROT is off by 100’s of thousands to millions (!) dollars. If you have ever made a mistake that cost $200,000 to $2,000,000 in your life before, you probably do not want to do it again. Moreover, if you never have before, why set yourself to do the unthinkable now. Knowing the rough estimate of a business based on ROT is in essence precisely that; setting yourself up to make a costly mistake.
Why is ROT so “rough” when estimating business value?
The Multiple: Most rules of thumb provide a variety of possible calculations. Typically, they express as an amount you multiply (the multiple) by some measure of business performance (gross sales, gross profit, or earnings). For example, a business in question could have a rule of thumb that states 3 to 5 times earnings. If an accurate description of the earnings is $500,000, the value could be too high or too low by $1,000,000! Alternatively, it might state 3 times earnings OR 80 to 100% of revenue. How could two businesses in the same industry with the same revenue, and different earnings be worth the same amount?
The Earnings: The earnings of the subject business must match the type of earnings used for the ROT multiple. This is not always obvious and can be complicated. What are the earnings for the multiple based on? Net Income, EBIT, EBITDA, Market Value of Invested Capital (MVIC) or Seller Discretionary Earnings? For many closely held businesses, the difference between each of these types of income streams can vary widely. Applying the wrong income stream to the ROT multiple, simply multiplies the amount of potential error in your value assumption.
In conclusion, even if knowing the value of a business is simply for “bragging rights,” I would personally be much more impressed if I knew the value of the business in question was generated by making the nominal investment in a professionally prepared valuation, rather than a valueless ROT multiple.
Links of Interest: