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The Rule of Thump

An article in the Atlantic Monthly refers to the emergence of a new term - the "rule of thump" - based on confusion with the term "rule of thumb".

 

Rules of thumb are often used by business owners to value a business. In some cases, the rule may be a general recognition that many small companies sell for a certain multiple of cash flow. In other cases, the rule of thumb can be more specific to particular industries (e.g. restaurants sell for 30% - 40% of annual revenues).

 

The use of these rules can be problematic. In many cases, there can be uncertainty as to the definition of the measure that is to be multiplied, e.g., the amounts that should be included in the cash flow number. Further, some industries have multiple rules of thumb that can suggest very different pricing levels for the same company.

 

Even assuming that a rule of thumb is valid, the rule will only generate a range of values for an average company in the selected industry. The subject company may differ from the average company in many different respects. Assuming two restaurants with annual revenues of $1 million, for example, the rule of thumb mentioned above would undervalue the restaurant that is located next to a major new shopping mall and primed for growth just as it would overvalue a restaurant in a declining inner city area.

 

Business valuators apply accepted valuation principles to the specific circumstances of the subject company and are able to avoid the pitfalls of reliance on rules of thumb. Valuators may consider rules of thumb but only as a reasonableness test of the valuation conclusion.

 

The bottom line is that reliance only on a rule of thumb will generally create unrealistic expectations on the part of a business owner who may take a beating when they come to market their company - in which case the "rule of thumb" does become more properly a "rule of thump".