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October 2012 Tip of the Month

Myths in Multiples.  Are Rules Of Thumb Useful?

Have you ever wondered where the actual term "Rule-of-Thumb" came from? We’'ve read that the Rule-of-Thumb" has been said to derive from the belief that English law allowed a man to beat his wife with a stick as long as it was no thicker than his thumb (of course, Jane,  you know that Marty doesn't subscribe to that theory).

Regardless, many industry-specific formulas or simple calculations have arisen over the years for valuing companies. Where do they come from? Originating in industry studies or surveys, the minds of business brokers, transaction databases, cocktail conversations, publications and other even less reliable sources, these so-called "rules-of-thumb" are often used -- and abused -- in value determination. Those who invest in the stock market, for instance, immediately become analytical in discussing earnings per share multiples, the basic “rule” for pricing common stocks. Yet while using such a rule or formula can be meaningful, without a thorough financial analysis coupled with some basic business judgment and common sense, it can be dangerous as well.

Think about it. Suppose an organization compiles statistics on 100 insurance agencies. The organization then averages all of the individual selling prices and calculates that the average agency sold for 100% of one year’s gross revenue. This creates a rule of thumb for valuing insurance agencies. The problem is that one agency may have sold for twice one year’s gross while another may have sold for half of one year’s gross. Thus, rule-of-thumb formulas may be accurate for businesses whose performances are about average, but other businesses will vary. To apply a rule of thumb to a business that varies significantly from the average is not appropriate. 

Let’s take this one step further and analyze two insurance agencies that provide personal and commercial policies and assume that the rule-of-thumb is as follows: Value = 100% of annual revenue. In this simplified example, this rule would provide the same value for both agencies even though their net incomes are substantially different.

But consider some other factors that might affect value:

  • Agency A has 125 clients, while Agency B has 75.
  • One of Agency B’s clients accounts for 25% of the agency’s fees.
  • Agency A has a long-term, noncancelable lease for its offices.

Some considerations unique to the insurance business might be:

  • The size and mix of commission income from life, health and business products,
  • Whether business is concentrated with a particular insurance carrier, and
  • The relationship of sellers to significant customers.

How about this same insurance agency that grosses $200,000 and is listed for sale by a broker at 1 times annual gross or $200,000, with the seller taking back a 120 month (10 year) note with no interest.  Assuming typical terms would call for a 7% interest rate per annum, this “effective” multiple would be 71.79% (ie present value of $143,573.

With Rules-of-Thumb, the multiples used may be known but, alas, the underlying transactions are not. There typically isn’t available sufficient data to derive multiple, insufficient information regarding the terms of the sale being compared to, while such Rules-of-Thumb are assumed to apply to the valuation of a “typical business”.  Well, exactly what is “typical”?  Each industry has its own unique considerations and each business has that much more. The salient point is to proceed with caution. Rules-of-thumb are not always based on a sound foundation. They are generalities and must be considered as such in their use and application. While they can help you determine a general value range, it may not be appropriate to rely on them as an authoritative means of valuing a company. They can be very useful in at least assessing the reasonableness of valuations based on other reasoned methods.

Let's see another illustration of how relying on a rule-of-thumb can cause us business appraisers to have a bruised thumb. Take two car washes in Camden County both doing $1 million in annual sales. Assume the car wash industry’s rule-of-thumb for a full service operation (versus a coin operated one) has been said to be worth one times annual gross sales.  Such suggests both enterprises are worth $1 million. In fact, a seasoned business appraiser might review these two separate operations and determine that the first one is actually worth twice the second. How can this be - two establishments in the same industry, in the same county, with the same gross sales having two different values?

Well, the first car wash is a brand new facility and is located in a more exclusive part of the county.  Its first year it grossed $250,000 in sales, its' second year it did $500,000, this year $1,000,000, and next year it expects to do $1,500,000. Its equipment is spanking new. It has good aggressive management. Everything about this business is trending upwards.

Car Wash #2 is located in an older, less desirable part of the county. A few years ago it was doing $2,000,000 in sales, now it is down to $1,000,000. The roof leaks. The property, plant and equipment are old and needs repairs. Basically everything about this business is trending downwards. Two businesses, same industry, same sales - completely different values. Restricting the analysis to a mere rule-of-thumb just won't pick up on that.

Our suggestion? Use Common Sense.  You can use rules-of-thumb to corroborate value determinations derived by more traditional methods if you combine them with a thorough understanding of the business and its financial history, sound business judgment and common sense. Use common sense but you can and probably should call a credible business appraiser with any questions you may have about rules-of-thumb or other valuation matters (us here at Abo and Company or even one of our colleagues with similar appraisal accreditations). This will help you determine an appropriate means of estimating value