Why rules of thumb mislead, and what to use instead

The rules of thumb owners hear

Almost every industry has a shorthand for value. A professional practice is said to be worth a multiple of annual fees, a service business a multiple of revenue, an accommodation or care business an amount per bed or per place, a medical or allied health practice an amount per active patient, and a transport business an amount per truck or per contract. Owners hear these figures from brokers, at industry events and from people who sold years ago.

Each rule compresses a valuation into one variable and one number. That is what makes it memorable, and it is also why it cannot describe any particular business well.

Why rules of thumb exist

Rules of thumb persist because they contain a grain of truth. Across many transactions in a sector, price does correlate loosely with revenue, fees or capacity, because those measures are visible early and are roughly related to earnings in a typical business. Brokers use them to screen enquiries, buyers use them to decide whether to look further, and owners use them because they are quick.

The problem is that the rule describes an average of past deals, most of which are not public, with terms nobody can check. It says nothing about the business in front of you, the date, the assets included in the price or the conditions attached. Our guide to valuation multiples explains why even a genuine transaction multiple needs a reason before it is applied.

Where they go wrong

A revenue rule ignores margin. Two businesses with the same sales can have very different profit because one pays higher rent, carries more staff or discounts more heavily. It ignores risk: a business with one customer providing half its revenue is not worth the same as one with two hundred customers. It ignores working capital, which a buyer must fund and which varies enormously between a business paid on delivery and one that waits sixty days for payment.

Rules of thumb also ignore the perimeter of the deal: a price "per bed" tells you nothing about whether the property, the equipment, the stock or the debt is included. And they ignore owner dependence. A practice whose patients follow a retiring principal out the door is worth less per patient than one where the relationships sit with the business. The difference between SDE and EBITDA matters here too, because a rule quoted against one earnings measure is wrong when applied to the other.

Two businesses, the same revenue, different values

The table below is a hypothetical illustration. Both businesses, their figures and the multiples are assumed for the example and are not benchmarks for any industry.

Hypothetical comparison: two businesses with revenue of $2,000,000 (figures assumed for the example)

A "one times revenue" rule would put both businesses at $2,000,000. In the example, Business A is worth less than that and Business B is worth far less, because the rule cannot see the margin, the concentration or the owner's role. Note also that the implied revenue multiples differ by more than four times between two businesses in the same sector with the same sales.

Using a rule of thumb as a sense check only

A rule of thumb has one legitimate use: as a rough check that a properly reasoned conclusion is not wildly out of line with what the market has paid. If a capitalisation of earnings valuation implies a revenue multiple far above or below the range typically discussed in the sector, that is a prompt to ask why. The explanation may be sound, such as unusually high margins, or it may reveal an error in the earnings or the rate.

What a rule of thumb cannot do is replace the analysis. A conclusion that starts from the rule and works backwards to justify it is not a valuation, and a reviewer will recognise it as such.

What evidence replaces them

The evidence that replaces a rule of thumb is specific to the business. It starts with three to five years of financial statements and a normalised earnings figure, with each adjustment explained and supported, as described in our guide to EBITDA adjustments. It continues with the facts that drive risk: customer and supplier concentration, contract terms, lease security, the owner's role, staff depth and the age and condition of equipment.

Market evidence comes from completed transactions in comparable businesses, adjusted for differences in size, margin, growth and terms, not from asking prices or anecdotes. Where transaction evidence is thin, a build-up of the required return provides a cross-check. The report should show the working and state why the chosen multiple or rate suits this business.

What to do before you rely on any number

If you have been quoted a rule of thumb, ask what it is based on, what earnings measure it assumes, what assets and liabilities are included, and whether the deals behind it completed on the terms described. Most of those questions will not have a clear answer, which tells you how much weight to give the figure.

Before making a decision about selling, ask for a signed valuation that shows normalised earnings, the reasoning for the multiple and the bridge from enterprise value to the amount you would actually receive. Valuation Group prepares business sale valuations for owners across Australia from Double Bay in Sydney, and the first conversation is free. Contact Jackson Wilson with your figures and the rule you have been quoted, and we will explain what a supportable figure would need to show.

General educational information. Examples are hypothetical and do not value a real business. The appropriate treatment depends on the purpose, evidence and agreed scope.