What advisors should know about the new valuation standard

What’s an RIA really worth?

Getting an answer, it seems, depends on what yardstick you use to measure it. Discounted cash flow has recently become the new de facto standard. But untangling how that model really operates, and what buyers and sellers should ultimately be keeping an eye on in the sales process, can be challenging.

“Advisors need to understand what the assumptions are when they’re working on something that will determine the value of their firms,” says Taryn Burgess, senior financial analyst for Mercer Capital, a Memphis-based firm specializing in RIA and asset management valuations.

Indeed, the stakes are high. The RIA M&A market is red hot, having just come off a record year that saw over 180 deals totaling $230 billion in AUM, according to Echelon Partners RIA M&A Deal Report.

A revenue-based valuation model had been the previous industry standard.

But as the industry has grown and advisory firms have evolved from practices to enterprise businesses, using discounted cash flow has become “the most accurate way of measuring value in the wealth management space,” says industry consultant John Furey, principal of Advisor Growth Strategies.

“The reality is larger firms and their advisors are using DCF [discounted cash flow] in their valuation method in some format,” Furey says.

The key element in the DCF model is forecasting expected future cash flows, according to Mercer.

To arrive at those numbers for wealth managers, valuation consultants establish a base rate of profitability, Mercer explains in its latest RIA Valuation Insights blog. That rate is determined by an advisory firm’s current revenue and cost structure, allowing for adjustments.

Since most firms use a fee-based revenue model, an ongoing level of revenue (“the run rate”) can be determined by multiplying assets under management at any given day by the business’ average realized fee structure.

The base rate of expenses is typically based on reported expenses over the most recent annual period, with adjustments made for items such as compensation, according to Mercer.

After subtracting expenses from revenues, the remaining cash flows are capitalized and represented by a terminal value, or the value of the enterprise at the end of a defined period. An appropriate discount rate is used to discount the forecasted cash flows and the terminal value to the present.

Applying a discounted cash flow valuation can also bring challenges, Furey notes.

“The first is determining a reasonable revenue growth rate,” he says. “There are many factors that make determining revenue growth challenging, including markets, business development success, and changes to pricing. The other element that inevitability gets debated is the risk rate.”

As a result, Advisor Growth recommends using DCF and “round off with a multiple approach using market comparables of similar firms. Also seek to understand the dynamics of an advisor client list which helps determine future revenue.”

Both RIA buyers and sellers need be aware of how appraisers will be looking at the business and applying the DCF methodology, Mercer’s Burgess says.

For example, RIA owners considering a sale of their practice may be concerned about excessive expenses diluting the firm’s DCF valuation.

While reducing headcount is a potential solution, Burgess cautions that advisory firms shouldn’t let employees go without considering the impact on clients.

“Don’t cut staff at the expense of relationships, because that’s what drives the business,” she says.

She also has advice for buyers who are valuing an RIA: Pay close attention to the actual fees the firm is charging, not the scheduled fees it advertises.

“There can be a significant gap between what a firm says it charges and what they end up charging clients they’re afraid of losing,” she says. “That can have an impact on future cash flows.”

Both buyers and sellers should pay close attention to compensation programs, which will be carefully analyzed “to formulate a normalized margin that can be used to value the firm,” according to the Mercer blog post.

And if the decadelong bull market begins to sputter, how could a recession impact an RIA valuation?

While depressed asset values and declining revenue would certainly compress margins, the overall effect may not be as bad as advisors fear, according to Burgess.

“Clients don’t necessarily leave when markets go down,” she says. “In fact, wealth managers have a unique opportunity in a bear market – they can bring on unhappy clients from competing firms and establish new relationships.”