Valuation Rules of Thumb – Fact or Fiction?

Have you ever heard, “That business is worth 2 times gross revenue”; or “one year’s earnings plus inventory”; or “3 times last year’s EBITDA” and so on? Perhaps you’ve had somebody say this to you about your business.

All of the above are rules of thumb. The question is should you be relying on these rules of thumb as a means of deciding the value of your company? Should you be using them to decide on insurance coverage (business interruption and/or life policies to cover the purchase of your shares), asset mix within your investment portfolio, the purchase price of a competitor’s business, or the asking and/or sale price for your own business?

Based on my experience, I would guess that a number of you have at least been tempted to use a rule of thumb to determine one or more of the above. If you have, you are not alone. Let’s face it, in the absence of detailed valuation information you probably didn’t have any other readily available ‘yardstick’ to determine or estimate the value of your business. It’s only natural then to use one of these rules of thumb in the decision making process.

Over time, rules of thumb have become somewhat entrenched in particular industries. Does this make them right?

Just so there’s no confusion here, I’m going to answer that question with a very loud NO, no wiggle room, not sometimes, just “NO!”

Let me demonstrate my point by the use of an example. One rule of thumb that has been tossed around is that a golf course is worth 3 times average gross revenue.

Let us assume we have two golf courses that are identical in every way with one exception, they have different bottom lines because one is more cost efficient than the other – lets take a look and see what our 3 times gross revenue rule of thumb would have us believe...

	Course A	Course Z
Gross revenue	$1,000,000	$1,000,000
Expenses	$800,000	$700,000
Net income	$200,000	$300,000

Course Z has improved it’s efficiencies through hiring a great green-keeper who uses only the most advanced fertilizers and maximizes labour efficiencies throughout the course. As a result, Course Z has been able to save $100,000 a year between maintenance and labour costs and this is reflected in a superior bottom line.

Now, which one would you pay more for?

Presumably you would pay more for Course Z than for Course A because you, as the owner, get to put an additional $100,000/year in your pocket. However, the rule of thumb would tell us that the price for both courses should be 3 times gross revenue or $3,000,000.

Doesn’t quite work, does it?

Granted, the gross revenue based rules of thumb are the easiest to shoot holes in, but the same can be done for some of the ‘more sophisticated rules of thumb’. They are sophisticated in the sense that they provide the illusion of complexity while not necessarily getting you closer to an answer.

One of the favourite rules of thumb is a multiple of EBITDA (EBITDA is earnings before interest, taxes, depreciation and amortization). In fact, this one is talked about by major investment houses across the country, on TV and in investment journals and newspapers everywhere. EBITDA is a popular measure because it approximates something you may have heard referred to as ‘free cash flow’ or cash available to the owners that they can choose to distribute to themselves. Am I saying that everyone is wrong? Well no, however, what I am saying is that you need to be very careful taking these types of rules of thumb at face value without doing more research.

Let’s consider an example of two companies that operate in a manufacturing industry. This industry uses a rule of thumb that states the value of a company is 5 times EBITDA. Let us assume that the companies in this example are identical in every way with the exception that one company has newer, better maintained plant and equipment requiring far less reinvestment in capital assets to sustain the business.

	Manufacture A	Manufacture Z
EBITDA	$750,000	$750,000
Required annual sustaining capital reinvestment	$200,000	$50,000
Net cash flow	$550,000	$700,000

Again, which company would you prefer to buy? Or, for a bit of a different take on things, how would you feel if you were the owner of Manufacturer Z and you were told that your business was worth the same as Manufacturer A?

Having said all of this you might think that rules of thumb have no purpose in the valuation arena but that’s not necessarily true either. Rules of thumb, be they right or wrong, do tend to approximate market transaction values (arguably for all the wrong reasons). So, they can occasionally be useful to the business valuator as a secondary valuation method to test the results arrived at using more appropriate valuation methodologies.

The message is this...

If you have to use rules of thumb, do so with caution. The value that you arrive at may be significantly different than the one determined by a professional business valuator.

Depending on where and how you are using a rule of thumb value you could be putting yourself at unnecessary risk.

Ask your RAN ONE accountant about the many ways you can enhance the value of your business through improving the profitability of your company.