Rules of thumb

An IPA Accounting Article

Over time, business brokers and professionals involved with mergers and acquisitions have, by industry, crafted loosely constructed formulas for estimating the value of a business enterprise. It is an inherently flawed process derived in large part from an analysis of buy-sell transactional patterns in a specific industry. Sometimes, they can serve a useful purpose - as a “sanity check” of the values derived through traditional valuation methods. However, in actuality they are nothing more than pure fiction.

As Tom Parker wrote in the introduction to his book Rules of Thumb, “A rule of thumb is a homemade recipe for making a guess. It is an easy-to-remember guide that falls somewhere between a mathematical formula and a shot in the dark.”

Rules of thumb are typically expressed as some multiple of earnings, such as 5 x EBITDA, where EBITDA = earnings before interest, taxes, depreciation and amortization, or 2 x Sales. Based on these “rules”, does this mean every company in a particular industry will sell for five times EBITDA or is worth two times sales? Absolutely not!

What if ABC Company has negative operating income? What if XYZ Company had a dramatic decline in sales at their fiscal year end of 2001 due to the economic devastation of 9/11?

The basic limitation inherent to rules of thumb is that they are intended to apply to a typical business. No one company is similar in every major aspect to any other company, nor is it similar to the combined aspects of many transactions viewed as a single fictitious typical company. Therefore, not only may a company may be valued incorrectly, rules of thumb may substantially value a company at less than or greater than the value derived through the application of professional valuation methodologies (as codified in statutes, case law, and applicable IRS advisory publications).

Valuation methodology, applied in accordance to professional valuation industry standards, considers the earnings capacity of the company in conjunction with its internal and external operational factors. In other words, a company must be valued on its own financial performance, internal operating conditions, and market base or location. These factors comprise the risk of the company or of the investment. Buyers demand a greater return on investment when purchasing high-risk companies; therefore, the higher the risk, the lower the value of the investment.

For example, one rule of thumb for a dry cleaning business is 1.25 x annual gross sales. Two companies, A and B, located in the same town are compared. Company A is located in a crime-ridden, economically depressed part of town. The business operates in a run-down building, utilizes old, outdated equipment badly in need of repair, and has experienced a spiraling downturn of sales. Company B, a relatively new business, is located in a thriving commercial/corporate office area with convenient access to the freeway. Company B has state-of-the-art equipment and a growing clientele base.

One year prior, Company A had annual sales of $650,000 but has gradually experienced a continuous monthly average sales decrease of 15%. Company B had gross annual sales of $650,000 a year ago but is now on track to reach over $1 million in the coming fiscal year. Are these two companies the same?

Should they be valued the same because they operate within the same industry? One year ago, based on the industry rule of thumb, Company A and Company B both would be valued at $812,500.

However, when considering the internal operations (the life of the equipment) and the surrounding market environment (prosperous versus declining), the two companies are nowhere near similar. Which company would a prospective buyer choose and invest $812,500? Company A? Or Company B?

And what about estate taxes? In calculating rule of thumb values, no consideration is given to gift and estate tax consequences. A professional business valuation conducted by a credentialed and experienced business appraiser assures the business is valued based on a thorough financial analysis and according to IRS standards and regulations.