Valuing an RIA reminds me of the classic western The Good, The Bad and The Ugly. You may recall the story of three distinct characters racing to dig up gold buried in a graveyard. Each of the characters is a succinct manifestation of the different ways to value an advisory firm:
- The Good: Discounted Cash Flow is simply the best way to value an RIA.
- The Bad: Book Value focuses on the value of the hard assets, which makes it an irrelevant valuation technique for our industry.
- The Ugly: Comparables, such as multiples of revenue or cash flow, may get ugly because it is an oversimplified valuation approach that could yield inaccurate valuation and a poor deal for one or both parties.
Despite the near-universal acknowledgement that the archaic two times revenue formula is the wrong way to value an RIA with over $100 million in assets, some advisors still have hesitancy to use the discounted cash flow technique.
Perhaps it is because the approach seems complicated, while the comparables approach is so simple. Sure, its easy to value a firm based on two times revenue or five times cash flow. But sophistication trumps simplicity for important matters, and valuing your biggest asset or investing your life savings to buy equity in a firm is vital.
MODELING THE FUTURE
The good news is that the discounted cash flow model is less intimidating than one might expect because it's based on the very concepts many advisors use to help their own clients plan for the future.
For example, when advisors help a client create financial plans, they work through a series of assessments, including projecting future income on an annual basis and planning for anticipated expenses such as college, retirement, health care and philanthropy.
Planners then create a likely scenario of how their income after expenses will unfold each year. Portfolios are then constructed based on an intelligent expectation of the growth rate of each asset class and an assessment of the risks associated with the expected returns.
WHAT DISCOUNTED CASH FLOW IS AND WHAT IT CAN DO
The discounted cash flow technique calculates a companys valuation by projecting its cash flows into the future, and then discounting these cash flows back to present-day based on the risks associated with the company. Its a quantitative process that examines the growth, the profitability and the risks associated with an organization.
There are three Ms when it comes to a discounted cash flow: The Model, the Method and the Modifications.
Model: The complexity of the model is directly related to its potential power. When done correctly, each new level of complexity is yet another layer of analysis moving the assessment closer to the accurate valuation number. The model is critical, but it is not enough.
Method: To determine the value of your firm, you need a methodical approach to populate the model, both with historical information as well as assumptions and projections for the future.
All parties involved in the process should be honest and analytical about what assumptions should be made, what is achievable and what is likely. Advisors need a process that accommodates both a detailed assessment of the individual line items (bottoms up), as well as a process to check if the numbers make sense from a reasonableness test (top down), i.e., are the margins, growth rates, expense categories, etc., rolling up to a rational place?
Modifications: Once the model is set, it is time to make appropriate modifications. Done properly, you have created a flexible tool, which not only determines the current value of the company, but also allows you to assess the value under a variety of circumstances.
For example, if you're contemplating a sale to a local firm that will reduce a number of costs, a few keystrokes can determine what the buyer is likely willing to pay. Perhaps an out-of-state buyer will provide access to a referral network in your city. Your company hasnt changed, but economics are different, so the valuation will be different and you will know precisely how different.
If an exiting partner of an acquisition target says that he or she is willing to work one more year or five more years, you can confidently offer either the seller a valuation of $X million if only one year of work is planned, or a valuation of $Y million if they plan to stay on for five years. There are an infinite variety of scenarios, but once you develop a comprehensive and flexible model, you are in a position to run any of them through the model to determine the modified value of the company.
- Stop Using Revenue Multiples: Better Tools for Valuation
- What Really Determines Your Firm's Value
- Advisors: What Your Firm is Worth