Rules of Thumb About Business Valuations, by Robert Wietzke, CPA, CVA

Whenever I speak to CPAs interested in business valuations, one subject grabs their attention-“Rules of Thumb”. After the presentation, several attendees always approach and ask for information about a book I’ve held up to illustrate one of several methods used to value a closely held business. The book is Handbook of Small Business Valuation Formulas and Rules of Thumb, third edition, by Glen Desmond published by Valuation Press, Camden, ME, in 1993.

Formulas have been used to value businesses for years, principally by business brokers and small business owners. These rules typically fall into four categories:

1)	Multiple of revenues;
2)	Multiple of earnings (net income, owners discretionary cash flow, EBITA, etc.)
3)	Multiple of book value;
4)	Multiple of a measured unit (Restaurant tables, hospital beds, subscribers, etc.)

These rules are nothing more than a rough starting point. Whenever I reference the book in my presentation, I add the statement “Be careful, thumbs come in many sizes and shapes!” Unfortunately, these rules have found their way into the valuation profession and are being used by inexperienced valuators in tax and litigation cases, principally due to their simplicity and ease of use.

Since an investors is focus upon their return on investment from future cash flows, the multiple of earnings seems most appropriate, as the other three do not assess the profitability of the business. None of the rules, however, provide sufficient information to assess the uniqueness of the business, such as management depth, customer relationships, industry trends, reputation, location, competition, capital structure and other information unique to the business.

In his book, Glen Desmond makes the following observation: “There is no single formula that will work for every business. Formula multipliers offer ease of calculation, but they also obscure details. This can be misleading. Net revenue multipliers are particularly troublesome because they are blind to the business’s expenses and profit history. It is easy to see how two businesses in any given industry group might have the same annual net revenue, yet show very different cash flows. A proper valuation will go beyond formulas and include a full financial analysis whenever possible.”

For example, a common rule of thumb for accounting practices is one to one and one half times annual revenues. A CPA associate of mine was offered a one-third-partnership share in her Firm based upon the formula. Upon examination of the books, we found that the partnership had accepted an assignment involving a valuation of a business for a pending divorce. The Firm never collected their fees, which represented a significant portion of their revenues in the year of the engagement. They were forced to borrow from their bank to pay staff salaries and office overhead. The interest on the loan had offset most of the Firm’s profits in the last two years. Would you pay $250,000 for a partnership in a firm with no cash flow?

The popularity of these “rules” is demonstrated by the wealth of data published on the subject. Desmond published the first edition of Handbook of Small Business Valuation Formulas in 1987. A second edition followed it and the third edition referenced above was published in 1993.

The AICPA Consulting Services Practice Aid 93-3 Conducting a Valuation of a Closely Held Business, American Institute of Certified Public Accountants, New York, NY, 1993 cautions against exclusive use of these formulas, but goes on to state “…. the valuer should not ignore what is being done in the industry. Frequently, an industry rule of thumb provides a representation of the perception that people have in the marketplace and should be one of the methods used in valuing the closely held business.” (Emphasis added). The practice aid, while intended to be an educational and reference guide to be used by Institute members, did not establish standards or preferred practices.

The State of Florida, however, apparently thought otherwise. When queried about the use of rules of thumb, an experienced practitioner in the State of Florida commented “… we are somewhat hamstrung here in Florida in that our State Legislature, in their infinite wisdom, has put in the statutes that a business valuation performed by a CPA in Florida must conform to the AICPA Practice Aid 93-3!”

Shannon Pratt, in his third edition of Valuing Small Businesses and Professional Practices, McGraw Hill, New York, NY, 1998, also cautions against exclusive use of these formulas. He does publish, however, the formulas commonly used for various types of professional practice valuations.

The 1999 Business Reference Guide, 9th Edition, edited by Thomas L. West, Business Brokerage Press, Concord, MA, contains over 300 Rules of Thumb in 100+ pages of the book. These rules are compiled from trade associations, industry experts and specialists. Today, web pages of sites devoted to small businesses discuss these rules as authoritative.

A CPA asked about his use of these formulas in litigation cases replied “Rules of Thumb cannot be ignored—they are a self-fulfilling prophecy in an industry if the formula has been widely disseminated.” He went on to state-“Therefore, we usually take the following approach:

1)	Identify the rule to show your knowledge of the industry and apply it.
2)	Should the result be close to the application of other more traditional valuation methods, then show it with no further remarks.
3)	If the results are not close, use the arguments (above) used in the ASA (Business Valuation) courses to point out the problems with formulas.

This article is being reprinted from the CPA Litigation Service Counselor with permission from Harcourt Professional Publishing Division, 525 B Street, Suite 1900, San Diego, CA 92101.