Rules of thumb are informal easy to use market based units of comparison which apply a “multiple of” to some indicator of the operating results of a business in order to estimate its Market Value.

Rules of thumb can be helpful if they are based on accurate data from the sale of reasonably comparable businesses in a free and active marketplace but in all cases they are backwards looking, do not factor in the terms of sale and make no adjustment for differences in risk, profitability and capital structure between the sample set on which the rule of thumb is based and the business to which it is applied.

Then there is the Chinese Whisper effect on rules of thumb. What starts out as a somewhat accurate generalisation e.g. “coffee shops typically sell for X times earnings” gets communicated through the grapevine and morphs into “coffee shops typically sell for X times revenue”. Big difference!!

Tom Parker in his book Rules of Thumb put it best.

“A ‘rule of thumb’ is a homemade recipe for making a guess. It’s an easy-to-remember guide that falls somewhere between a mathematical formula and a shot in the dark.”