Des Peelo outlines why prospective sellers and buyers should not rely on rules of thumb as a basis for the valuation of a business.

Commentators, financial analysts, investment advisors and others often like to believe, or at least promulgate the belief, that the valuation of a business in a particular sector can be stated as some simple formula such as ‘X times turnover’, a percentage of something, or a multiple per unit (that unit being a hotel room, a subscriber and so on). Sometimes, advisors charge extraordinary fees for imparting such wisdom in an apparently knowledgeable manner. This wisdom is known collectively as ‘rules of thumb’.

Common sense dictates that the reason for acquiring a business, or an interest in a business, is to obtain an economic return (i.e. future profits). However, the use of rules of thumb in valuing a business is at best arbitrary, is not based on economic assessment, and carries little if any logic beyond being a kind of shorthand valuation usually put about within the business sector itself. Financial press commentators too can create a norm by simply relating the sale price of a particular business to some underlying statistic in the business, such as the price being a certain multiple of the turnover, the price per hotel room, the number of subscribers divided into the price, the price expressed as a percentage of the amount of funds under management. This norm, having been published and thereby accorded a status, is then perceived as a comparison or benchmark for any future transactions in the same sector, even where it bears little relation to the reality of the marketplace.

The underlying premise to a rule of thumb basis of valuation, if there can be a premise at all, has to be a belief that profitability in the sector does not vary greatly and that therefore, almost any company in the sector will have the same characteristics. This is obviously irrational because the following factors may differ: 

• Rented versus owned premises;
• Different levels of borrowings;
• Young versus mature businesses;
• Use of technology;
• New versus old equipment; and
• Age and experience profiles of key employees.

A norm is an average. An average, by definition, includes high and low and does not distinguish between a good and a bad business. An average is not excused by saying that it relates to a typical business. A business may be described as typical only insofar as it has, for example, a turnover or characteristics similar to other businesses in the same sector. However, one or two common characteristics do not negate the differences between businesses, as set out above. A potential purchaser should be wary of a valuation based on a rule of thumb approach. Examples abound of unwise acquisitions made by following such an approach, sometimes referred to as ‘formula purchases’. In the UK, the practice of ‘formula purchases’, now much more muted, included undertakers, hotels, pubs and restaurant chains, recruitment agencies, insurance brokerages, advertising agencies, estate agents, newspapers, pharmacies and even nursing homes. A high proportion of these acquisitions subsequently unravelled. It was mainly ‘people businesses’ (such as estate, advertising and recruitment agencies) that lost the most money for their new owners.

It can be the case, however unscientific, that certain valuations are based and/or accepted on something akin to rules of thumb. For example, the Revenue work manual on the valuation of shares regarding Capital Acquisitions Tax states the following: “Companies which own or operate licensed premises or restaurants or whose business is in the services sector, such as insurance brokers, quantity surveyors, architectural practices, consulting engineers, legal etc. are normally valued on the basis of a multiple of their turnover, fees or commissions.”

In the case of a professional practice, notably accountants and solicitors, the valuation is probably seen as a price for giving a new entrant a head-start in the business; or alternatively providing a bolt-on addition to an existing practice. Experience suggests that there is some fall-off in respect of repeat business when a practice changes hands. Hence, a transaction on a rule of thumb valuation that is based on expected repeat fees may defer some of the consideration based on the actual outcome. Any fall-off is usually ameliorated, however, by parallel working for a period with the outgoing practitioner.

In summary, relying on a rule of thumb as a basis for valuation is flawed. If a rule of thumb is to have any use at all, it can be no more than a preliminary indication of a seller’s expectation of price. This expectation must be met by the reality that a valuation is about market value, not a pre-ordained norm. A potential purchaser, properly advised, will not buy solely on a rule of thumb valuation.

Des Peelo FCA is the author of The Valuation of Businesses and Shares, which is published by Chartered Accountants Ireland and now in its second edition.