Accounting 101: Rule of Thumb Valuations
By Andre Pontoni | October 31, 2004
These methodologies are often called "rules of thumb" and are specific to a particular industry. While I am not a proponent of rules of thumb, I do believe a professional valuator can benefit by their correct use.
Essentially a rule of thumb is an average of prices from a number of transactions converted to a multiple linked to a common element found in all companies in a particular industry.
It is important to note that rules of thumb are considered an industry average, which factor in both the highs and lows of industry transactions.
I have found that in applying the same rule of thumb blindly to all companies in a particular industry, likely errors will result.
Each Company has a different history and future and therefore specific adjustments are required to normalize a Company's earnings. Applying a rule of thumb or multiple blindly to a Company's earnings without consideration for these adjustments will either overstate or understate value. In addition, each Company is at a different point in its business cycle, some in a start up phase whereas others may have peaked. General rules typically do not account for the growth potential of a particular company.
Company A in a particular industry may have a different financial structure than Company B. That is, Company A may have less debt and a stronger working capital position than Company B. However, when applying generic rules of thumb to a company's earnings, financial structures between companies are often assumed to be consistent. This of course is a fallacy. If Company A and Company B had similar earnings, an application of a rule of thumb may lead the nonprofessional to believe that Company A and Company B had equal value.
Companies in the same industry may have different capital reinvestment policies. This being the case their sustaining capital reinvestment requirements at any one time will often be different. Applying a general rule of thumb will not account for these differences.
Similarly, Company A may own assets, which are not used in the operations; I have seen rules of thumb simply lump these assets with the operations. Valuation theory indicates that the value of these assets are in addition to the operations of the business.
Other issues, which may not be accounted for in rules of thumb, include economic dependence on customers and key personnel. Usually a formal valuation will account for these issues in the multiple, which is used to capitalize earnings. Company A may have higher economic dependence than Company B and is therefore perceived to have higher risk. A formal valuation will account for this difference usually in the multiple applied when capitalizing a Company's earnings.
There are many more examples that can be shown where rules of thumb fail to account for unique differences between Companies in the same industry. A professional valuation will at a minimum assess these differences and account for them appropriately in determining fair market value. Rules of thumb are useful in determining whether you are in the ballpark. If you want to be on base, I suggest a professional valuation.