David Anderson is principal of David Anderson & Associates, a Philadelphia forensic accounting firm that provides a full range of forensic accounting services including business valuation, fraud investigation, and fraud deterrence programs in Philadelphia and the Delaware Valley.
Some trade associations and business brokers, among others, use what are called Rules of Thumb to explain to business owners the “value” of their company. While this may provide some general ballpark approximations of worth, Philadelphia forensic accountant and Certified Valuation Analyst David Anderson said there are many problems with relying on this general principle that could be generally close but not completely reliable or accurate.
Anderson – principal of David Anderson & Associates, a Philadelphia forensic accounting firm that provides a full range of business valuation services in the Delaware Valley – explains there can be significant differences between the value developed using a Rule of Thumb and the value determined by a qualified professional business valuator using professional valuation standards.
In the context of business valuation, Rules of Thumb are theoretical units of comparison. They usually are expressed as a range of multiples of either sales or SDE (seller’s discretionary earnings, which equal the total of owner’s compensation and net profit). For example, a Rule of Thumb for a certain industry may be that a business is worth 1.1 to 3.8 times sales or 3.5 to 6.4 times SDE.
Rules of Thumb generally presume the business being valued is an average business. They may be based upon transactions that represent the sale of the assets of a business or, instead, that represent the sale of the equity of a business. Anderson – a forensic accounting expert in Philadelphia with experience conducting business valuation services in the Delaware Valley – said Rules of Thumb also may be based – in some cases – on the presumption the business buyer is paying 100 percent of the purchase price in cash or – in other cases – on the presumption the business buyer is paying a combination of cash and debt or cash and a percentage of future earnings.
Unfortunately, most Rules of Thumb (including those in many business reference guides) provide limited information, if any, regarding the specifics of the underlying transactions which gave rise to the Rule of Thumb ranges. Accordingly, Anderson, a Certified Valuation Analyst in Philadelphia, said such Rules fail to recognize differences in profitability, business lines, customer concentration, capital structure, management, geographic location, and other important factors. Furthermore, local Rules of Thumb may differ from national Rules of Thumb.
Given the shortcomings of Rules of Thumb, most professional business valuation standards discourage using Rules of Thumb. For example:
- NACVA (the National Association of Certified Valuators and Analysts) professional standards state “Rules of Thumb are acceptable as reasonableness checks, but should not be used as a standalone method.”
- AICPA (the American Institute of Certified Public Accountants) professional standards state “A Rule of Thumb is typically a reasonableness check against other methods used and should generally not be used as the only method to estimate the value of the subject interest.”
- ASA (the American Society of Appraisers) professional standards state “Rules of Thumb may provide insight into the value of a business, ownership interest, security or intangible asset. However, value indications derived from the use of Rules of Thumb should not be given substantial weight unless they are supported by other valuation methods and it can be established that knowledgeable buyers and sellers place substantial reliance on them.”
Similarly, the courts rarely accept Rules of Thumb as a valuation method. Anderson, principal of David Anderson & Associates, a Philadelphia forensic accounting firm that provides a full range of business valuation services in the Delaware Valley, cited a case addressing this issue was In re: Marriage of Hagar – 2010 WL 4807559 (Iowa App.) (Nov. 24, 2010). In this case, a divorcing couple in Iowa had a disagreement regarding the value of a jointly owned dry cleaning business. The husband’s expert made four “calculations” of the value of the business ranging from negative $120,000 to positive $79,329. The expert testified:
“… this is not a valuation. This was a computation utilizing Rules of Thumb that are documented as industry standards but not using the judgment, simply using calculations following each of four suggested formulas”
Furthermore, on appeal, the wife pointed out the husband’s expert’s use of Rules of Thumb and industry standards did not require the same professional judgment as a complete valuation. In this matter, Anderson, a Certified Valuation Analyst in Philadelphia, said the appeals court rejected the husband’s expert for not using judgment and using Rules of Thumb instead of issuing a professional opinion of value.
Rules of Thumb can be useful for obtaining a ballpark range of value for a business. However, a professional business valuation is necessary if the value of a business needs to be determined in any of the following situations:
- Divorces
- Shareholder Disputes
- Economic Damages Calculations
- Litigation
- Tax Matters Such as Gift Taxes and Estate Taxes
- Accounting Compliance Matters (For Audits) Regarding Goodwill Impairment; Purchase Price Allocation; And Other Fair Value Measurements
- Sale, Purchase or Merger of a Business
If you require the services of a Certified Valuation Analyst in Philadelphia or any other forensic accounting services in Philadelphia and the Delaware Valley, please contact the Philadelphia forensic accounting firm of David Anderson & Associates by calling David Anderson at 267-207-3597 or emailing him at david@davidandersonassociates.com.
About David Anderson & Associates
David Anderson & Associates is a Philadelphia forensic accounting firm that provides a full range of forensic accounting services in Philadelphia and the Delaware Valley. The experienced professionals at David Anderson & Associates provide forensic accounting, business valuation, fraud investigation, fraud deterrence, litigation support, economic damage analysis, business consulting and outsourced CFO services. Company principal David Anderson is a forensic accounting expert in Philadelphia who has more than 30 years of experience in financial and operational leadership positions and is a Certified Public Accountant, a Certified Valuation Analyst and a Certified Fraud Examiner in Philadelphia.
