Valuation Truths: Beware of Rules of Thumb

Many have heard that if you’re in the fill-in-the-blank industry, your business should sell for a fill-in-the-blank number times fill-in-the-blank measure.

These types of guidelines are widely discussed and generally accepted. There’s only one problem: they are rarely correct. Rules of thumb are not an accepted method of valuation and can be quite misleading if buyers or sellers look to them for valuation numbers.

The problem lies in the fact that they ignore some basic truths relevant to valuation:

Once a buyer gets a chance to conduct thorough due diligence, its perception of the target’s value may change. PPAs are meant, in part, to address such revised assessments. But they’re also intended to account for fundamental changes – such as the availability of capital – in the weeks or months between the transaction’s signing and closing.

Specific circumstances matter. Every business is different in terms of its characteristics, and every deal is different relative to what’s included and the terms of the sale. One company may have great growth potential and profitability and another in the same industry might be dying. So to say that two businesses in the same industry will share calculation of value ignores the fact that value depends on the specific circumstances of each company.

Economic conditions count. How can the same rule of thumb apply today as it did during the recession? It can’t. Economic conditions influence how much people are willing to pay for just about everything, from food and airline tickets to businesses. Rules of thumb ignore economic factors that influence pricing.

The world changes. But rules of thumb do not. Legal and regulatory requirements, supply and demand fluctuations, and social and political upheavals are just a few of the factors that can influence value. And while the world is always evolving, rules of thumb rarely adapt.

Most valuation professionals ignore rules of thumb except as a “sanity check.” Even the authors of books about rules of thumb warn that they shouldn’t be used as a primary method of assessment.

So forget what you hear from your friends and family. Rules of thumb are not reliable.

If you need reliable valuation input, ignore rules of thumb and contact us.