Are ‘Rules of Thumb’ Useful?

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.

The Most Important Number Your Accountant Never Told You About

At one time or another, every small business owner wants to know what their business is worth…even if they aren’t the least bit interested in selling.  Many will ask their accountant for advice.  The trouble is that while accountants are usually good at accounting, they are usually not so good at valuing small businesses…especially when the business owner is also a client.  In the accounting world, people are typically trying to minimize taxable income in order to pay less tax, while in the small business appraisal world, taxes are not a consideration in estimating value.

Naturally, business owners try to avoid paying more taxes than they have to.  This is called tax avoidance, which is legal, and not to be confused with tax evasion, which is illegal.  For the small business owner, this can mean having a company car, health insurance, and other perks, paid in pre-tax dollars by the business, rather than after-tax dollars by the owner.  Of course, some owners are more creative or aggressive in how they minimize their taxable income.  In addition, owners’ salaries can vary wildly, even among similarly sized businesses within the same industry.  Consequently, the “bottom line” (pre-tax profit or earnings before tax) from an accounting standpoint, can be very misleading.

EXHIBIT A

Looking at Exhibit A, one might be tempted to conclude that  Blue Widget Co. is the more profitable, and therefore, the more valuable company.  Fortunately, most business owners and their accountants would correctly want to “add back” the owner’s salary, as this is typically at the discretion of the owner(s) themselves.

EXHIBIT B

Exhibit B demonstrates that, after adding back each owners’ salaries, the picture of profitability changes substantially.  Instead of Blue Widget Co. being $50,000 more profitable than Red Widget Co., they are equally profitable at $180,000 each of EBT plus owner salary.

This is not the end, however.  As most business owners understand, there are other business expenses that benefit the owner(s), but are not necessary to operate the business.  These are often referred to as perquisites (owner perks).  Since owners’ perks vary from company to company, it is important that these perks are added back in order to compare companies on an “apples to apples” basis.

EXHIBIT C

Exhibit C shows the full calculation of Discretionary Earnings to the owners of each company.  When measured by Discretionary Earnings (DE), Red Widget Co. is more profitable than Blue Widget Co.  Without understanding the Discretionary Earnings of a business, there is no way to properly estimate its value.  This is why Discretionary Earnings is the most important number every business owner should understand.