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Are you in the Ballpark or Out in Left Field? Valuation and Rules of Thumb

Business owners often question the need for a formal valuation process and in many cases have strong preconceived opinions of the value of their business. Often these opinions are informed by industry “rules of thumb”. Industry rules of thumb calculate value using industry specific metrics, typically consisting of operational or financial performance metrics. For example, if a rule of thumb for a software business is 2.0 times annual revenue, a company earning $1.0 million in annual revenue would have a calculated value of $2.0 million.

Several industries in which rules of thumb are well-established include:

  • Car Dealerships – dealers often cite ‘Blue-Sky’ multiples, being the amount of goodwill value of the dealership. ‘Blue-Sky’ value is calculated as pre-tax income multiplied by the ‘Blue-Sky’ multiple which is typically derived from industry publications and informed by precedent transactions. ‘Blue-Sky’ multiples vary by vehicle brand and are usually higher for luxury brands. Total dealership value is calculated by adding the reported book value of the dealership’s assets to the ‘Blue-Sky’ value.
  • Asset Managers – multiples of assets under management (AUM).
  • Professional Services Firms (law and accounting firms) – multiples of revenue.
  • IT Services Businesses – multiples of revenue segmented by the type of service with higher margin managed service revenues typically attracting higher valuation multiples than lower margin product resale revenues.
  • Oil and Gas – multiples of barrels of annual oil production, multiples of oil reserves, and multiples of cash flow per barrel.

The foregoing rules of thumb are derived from industry experience, historical transaction activity and hearsay and are based on industry wide generalizations. In assessing the rule of thumb, it is also important to understand how the rule of thumb was developed. Business owners often rely on word-of-mouth metrics gleaned from casual conversations. Such metrics can be inaccurate or misleading and typically do not consider deal structuring (cash, shares and/or earn-out), business specific conditions, or value drivers.

Rules of thumb are attractive given their simplicity and cost-efficient application. In our work, we consider the implications of well-established rules of thumb, but the analysis is secondary to our work with fundamental valuation approaches (commonly based on our assessment of free cash flow) and is most often used as a reasonableness check. While valuation rules of thumb are popular, it is important to recognize their shortcomings, to avoid undo reliance and to treat the findings with caution. In our view these techniques are most often best considered as a secondary valuation approach.

To illustrate the potential shortcomings of a rule of thumb, consider two law firms that report average annual revenue of $5.0 million. Firm A provides recurring legal services to a stable base of ‘sticky’ clients. Firm B generates revenue on a project-by-project basis, fees are contingent on success and the firm relies heavily on one lawyer to drive business. Applying a simple rule of thumb multiple of revenue would result in the same value for both firms. However, Firm B’s revenue profile is riskier than that of Firm A. Other factors such as differences in size, geography, and product offerings can also distort valuation conclusions derived from a rule of thumb. It is also important to assess whether generally accepted metrics have changed over time – for example, a ‘Blue-Sky’ multiple from 3 years ago may not be relevant today.

In industries where rules of thumb are widely established, we consider it a best practice to consider the rule of thumb as a secondary valuation approach typically supported by a primary cash flow or earnings-based valuation analysis. Differences between the primary valuation analysis and the rule of thumb should be considered and explained and may be indicative of the need for further analysis.

Consistent with our view, we note that Canadian tax authorities and Courts have generally found valuations based solely on rules of thumb to be unsubstantiated:

  • In R.R.A.G. v. S.N.G., one expert valued a mutual fund brokerage for purposes of a marital dispute using a rule of thumb because “that’s what the industry does.” The Court concluded that the rule of thumb was not appropriate, and the value conclusion was not supported by another substantial valuation method.
  • In L.M.H. v. K.J.H., the value of a farm and dairy assets was determined using quota-based valuation metrics. The Court challenged the use of the rule of thumb “as a dependable test for the valuation of a business” given the wide range of factors affecting businesses in the industry.
  • In Elliot v. The Queen, the Tax Court of Canada found that one expert placed too high a reliance on the use of a rule of thumb to value an accounting practice. The Court concluded that “the rule of thumb has its place, but the other methods should have been given more weight.”

While not dismissive of the use of a rule of thumb technique, the view seems to be that analysis should be validated by fundamental valuation analysis and other market evidence.

In summary, valuation rules of thumb can be a useful tool for assessing a ballpark valuation and will inevitably continue to be used by the business community. However, if the valuation is being used in a formal sales process, for tax reporting or litigation, it is important that the valuation rely on fundamental valuation techniques and rigorous analysis.