Whether you are planning to sell your business to an outside party, thinking of implementing an internal succession plan to transfer ownership to the next generation, or considering the strategic acquisition of another wealth management firm, an understanding of the true drivers of valuation is critical.
COMMON FORMULA: REVENUE x 2
The simplest and most common approach to valuing a financial advisory firm is typically “two times last year’s gross revenue.” Under this rule of thumb, a business that generated $500,000 in revenue last year is worth $1 million.
If only it was that simple.
Unfortunately, in most cases this logic is faulty on two levels. Let’s look at each weakness in turn.
1. The “revenue” approach doesn’t take into account the quality of the business. A multiple-based approach cannot capture things like firm profitability, effort to service and retain clients and growth potential of the current book. For an example, put yourself in the potential buyer’s shoes and consider two businesses that generated $500,000 in revenue last year. Which would you rather own?
The "2 x revenue" approach values both firms at $1 million. However, it is quite clear that owning Firm B is more desirable for the following reasons:
- It has a smaller number of large clients, which is typically easier to manage and requires fewer resources to service than a business that has 10 times the number of clients.
- It has younger clients in accumulation phase, and is therefore likely to generate more revenue than a business with older clients in decumulation mode.
- Fee-based revenue is usually more predictable.
2. The “2 x revenue” approach measures the past instead of the future. Buyers evaluate businesses based on a firm's potential. Of course, historical track record and current state matter -- but a buyer cannot gain from what has been achieved in the past.
BETTER METHOD: FUTURE PROFITABILITY
So we think the appropriate way to value a business from a buyer’s perspective is to focus on future profitability, and then discount those profits to the present. Put another way, an enterprise's value is the present value of future after-tax profits, minus the market value of debt. (For the purpose of this description, we assume no debt is held on the balance sheet.)
Three things drive enterprise value:
- Current profitability: The amount of money left over after all compensation and overhead expenses are paid, including the salary an advisor pays himself.
- Sources of growth: The amount of increase in profits that is reasonable to expect in future years. This is highly dependent on capital markets assumptions, ability to acquire new client households and the growth potential of the current book of clients.
- Profit sustainability: An objective assessment of the riskiness of future profits -- essentially, a “discount rate” that can be used to measure future profits in today’s dollars. It encompasses aspects such as vulnerable client relationships, the level of client turnover, the level of fee-based business, clients’ affinity to the firm rather than to a key-individual, and the level of “institutionalization” of the firm.
This type of valuation analysis can help you make smarter strategic decisions. If you are considering the sale of your wealth management business or acquiring a business, for instance, think about strategies that maximize value and positively contribute to one of the three enterprise valuation drivers.
Does a given strategy increase profitability? Does it increase growth potential? Does it increase the sustainability of future profits?
In the end, how you manage your business is every bit as important as how much revenue it generated last year.
Johann Schneider is program director for capital market insights, Private Client Services - Russell Investments. To see this post in its original form, with more information and full disclosures, visit Russell's Helping Advisors blog.