Rules of Thumb Are Useful Tools, But…
Rules of thumb have been around almost as long as there have been thumbs. People enjoy using a measurement that is always at hand, as it were, without having to do a lot of complicated research and analysis. Unfortunately, there is no standard thumb size so each measurement performed by each individual with their own thumb will be different than any other’s measurement of the same thing. That sort of confusion has spawned a multitude of different rules of thumb that different experts have formulated to help themselves perform various measurements. One example would be a measurement of the length of a specific piece of wood. Depending on the size of the individual, a rule of thumb of “three handspans in length” might be equal to another’s “4.5 handspans in length”. It doesn’t mean that the length of that board changed, it just means that one individual has smaller hands than the other. The next set of carpenters to come by and measure that same piece of wood, remembering the easy rules of thumb mentioned by those before, will be expecting to see a length of wood of between 3 and 4.5 times the width of their hands, but it will actually be a slightly different multiple of handspans for each carpenter.
When it comes to business valuation, pricing a business for sale, or simply checking to see what it might cost to buy out a partner, rules of thumb are an easy option; but there are so many variables affecting that answer, that the best answer one can get with a series of rules of thumb is really a range of values, and that range will be different for each thumb used to measure it. Not to mention that rules of thumb are also always changing and growing over time as market conditions and businesses evolve.
Let’s explore that concept about rules of thumb changing over time. I own a copy of a book first published in 1987, but my copy is the third edition and was published in 1993. It is the Handbook of Small Business Valuation Formulas and Rules of Thumb by Glenn Desmond, published by Valuation Press. In it there is a rule of thumb for Automobile Dealerships that says the following:
Use a stabilized Owner’s Cash Flow (OCF).
OCF multiplier typical range: 0.0x – 1.25x OCF
Formula assets included in the indicated value:
Add fixed assets at market value to formula assets.
Please note that the above ‘rule’ can be summarized by saying, “Apply a multiple to earnings, then add fixed assets.” What also needs to be pointed out is that the multiple range varies from zero to 1.25 times, and the selected multiple depends on a variety of other factors described in the book, such as the type of dealership, trends in the national economy, the location of the facility and the terms of the lease.
Let’s use the following simplified sample data for pricing an auto dealership owned back in the early 1990s:
· Owner’s Cash Flow - $100,000
· Fixed Assets at Market Value - $250,000
· Annual Sales - $1,000,000
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