What is a Rule of Thumb?
At some point, every business owner has seen or heard of a quick and dirty way to value their business…a rule of thumb. Sometimes they read about it in a magazine or trade journal. Others have heard it from their accountant. Some are quite simple…others more complex…but never so much so that the owner can’t take a napkin and about 30 seconds to figure it out.
So, before we get too far into the topic, just what are “rules of thumb”? In general, a rule of thumb is a quick, simple and non-precise way to evaluate or measure something. Supposedly, the term originated with carpenters and wood workers who would use the width of their thumbs as a quick measurement of one inch rather than stopping their work to hunt for a ruler. We have all heard rules of thumb in many aspects of our personal and professional lives. In driver’s ed (or traffic school), we’ve heard the rule of thumb…stay one car length back for every 10 miles per hour of speed. A pinch of salt is certainly more convenient than using a measuring spoon. The ‘Rule of 72’ measures how long (in years) it takes for a sum of money to double at a particular interest rate. Divide 72 by 8 and you get 9. So at 8% interest, it will take 9 years to double your money….approximately. Each of these rules of thumb are easy to use and remember…and accurate enough to do the job.
Using Rules of Thumb to Value Businesses
It makes sense that people want to discover and use rules of thumb. They make things easy, and that’s generally a good thing. So it shouldn’t surprise anyone that rules of thumb have been developed to help people value their businesses…and there are rules of thumb for almost every industry imaginable. In most cases, these rules of thumb utilize sales revenue because this is something that is relatively easy to determine and calculate. So a rule of thumb for valuing a business in a particular industry might be something like…your widget-making business is worth 75% of sales. So, if your annual sales are $1,000,000, this rule of thumb suggests a value of $750,000.
Sounds simple enough. However, ultimately earnings drive value, not revenue. [see article on discretionary earnings] Owners don’t support themselves and their families on revenue…they do it on earnings…what is left over after paying the bills of the business. Sales of $1,000,000 tell us nothing about what is left over…in earnings. Does it make sense to say that a business with sales of $1,000,000 and earnings of $0 would be worth the same as a business in the same industry with sales of $1,000,000 and earnings of $200,000? Of course not. And this is where rules of thumb for business value fall short. Unlike most rules of thumb, like a pinch of salt, or the Rule of 72, which are ‘close enough’ to be useful, rules of thumb for business value can lead to results that aren’t even in the ballpark.
To Use or Not To Use
So why do people still use rules of thumb? Well, it’s fast, easy, and cheap (as in $0). And usually there is no downside because the business owner is just using the rule of thumb for general information, and not actionable information (i.e. relying on it in an actual transaction scenario). The problem is that this “information” can be (and usually is) completely wrong. And even if it is not being used in a transaction or other actionable situation, it can negatively affect long-term planning decisions. As a wise man once said, “it’s better to have no information than wrong information.” If that axiom holds true, then it is better to ditch the rules of thumb and either remain in the dark, or invest in a professional market business appraisal. Just as you wouldn’t trust a bridge built by a guy using his thumb for measurement, you shouldn’t measure the value of a business using rules of thumb.