Rules of thumb can serve as useful sanity checks for controlling interests that are generally valued using more technically sound methods.
However, they should not be used as the sole method of business valuation for a few reasons:
Based on Unreliable Word of Mouth
Rules of thumb have always been largely based on folklore or word of mouth and not proven data and in-depth statistical analysis. Therefore, it should be taken with a grain of salt, and never solely used to base your entire valuation.
Suppose an owner hears through various channels that a competing business sold for 80% of revenues? The firm has no means of verifying the rumor’s accuracy or underlying details.
Oversimplify the Formula
They fail to account for differences between industry participants such as non-operating assets, niche markets, management quality, operating risks or geographic location. They don’t consider many of the underlying factors, risks and attributes specific to a business that directly affect its overall value.
Furthermore, ambiguous rules of thumb leave many unanswered questions.
Take for example the prevalent rule of thumb for manufacturers of three to five times earnings:
- Does the term “earnings” refer to net income; earnings before interest, taxes, depreciation and amortization (EBITDA); or something in between?
- Does the formula assume an asset or a stock sale?
- Does it include real estate, inventory and intangibles?
- Does it generate a cash equivalent price, or did underlying transactions involve extended payouts, such as earn outs or seller financing?
Irrelevant and Dated
As demand fluctuates, old transaction data may lose its relevance. Pricing multiples are affected by general economic conditions, industry forecasts and trends. For instance, an influx of new competitors, revolutionary technology or industry roll-ups might have an impact on pricing multiples.
Implausible in a Court of Law
Courts reject rule-of-thumb valuations if they are used as a stand-alone method.