Rules of thumb can be convenient and dangerous. When at the butcher, its good to know that roughly half a pound of meat will feed a person. Using this rule of thumb helps ensure that your dinner guests dont leave hungry or you dont waste a few extra dollars per person.
But rules of thumb can also oversimplify important decisions and lead to incorrect answers. Case in point: the outdated adage that your portfolio's fixed income allocation should equal your age.
So when a rule of thumb becomes dangerous, it becomes a rule of dumb.
When it comes to M&A valuations in the independent advisor industry, multiples of revenue or cash flow are the rules of dumb. Also known as the market approach, multiples can be a convenient way to discuss rough valuations on a golf course or over a cocktail.
MULTIPLES: 'DANGEROUS AND IRRESPONSIBLE'
But when it comes to actual dealmaking, using multiples is a dangerous and irresponsible way to value RIAs. Unfortunately, it is not uncommon to hear of advisors asking their employees to risk their savingsoften their life savingsto become a company shareholder based on cocktail napkin math.
So why are multiples dangerous? We can start at the most basic level: The gut check. Have you seen that beef jerky commercial that ends with the quote So easy, its dumb? Well, at some point, we apparently moved into the jerky aisle. How does your gut feel when contemplating that a 5x cash flow multiple is essentially valuing a multimillion dollar firm with math a ten-year-old can do in her head?
Gut check: So easy, its dumb.
But lets get more technical. How would you determine the exact number to use as the multiple? Should it be 2x revenue? Or 2.3x? Or what about the multiple of cash flow? Should it be 4x? Or 6x? Or 8x?
Clearly, we need to get this multiple rightlife savings are hanging in the balance. So, how would one scientifically determine what the right multiple should be? What is the exact formula to determine it?
Answer: There isnt one.
HOW COMPARABLES WORK
There is no mathematical equation to accurately determine what a multiple of revenue or cash flow should be. It is a subjective assessment based on implied comparables of what a firm is worth.
The comparables approach is a process of comparing a subject company to its peers and then calculating its value based on a relative multiple.
A P/E ratio is a great example of a comparable that most people are familiar with. To be effective, the market approach requires a peer group where recent transaction values are known, terms of the deal are disclosed, and the details of the companies operations are transparent.
This process works very well for publicly traded firms, and is why the comparable P/E ratio has become a household name. All of the required information is a few keystrokes away.
Now, try to create your companys own comparable. Can you google the valuation, deal terms, and reams of business operations data of your 30 closest competitors? Unfortunately, you cannot.
WHAT MULTIPLES CAN AND CAN'T DO
This information isnt accessible for privately held companies like RIAs, so there are no comparisons to be made. Quite simply, the multiples method cant give the sufficient amount of detail required to accurately determine the value of an RIA.
So, do multiples have a place in equity-related discussions? Absolutely. They can be valuable shorthand to scope a target acquisition candidate or to use in estimating a firms value in strategic discussions.
However, when shares in an RIA are being sold, the downside of using a rule of dumb isnt limited to a late-night raid on the fridge or losing a few extra dollars on a fillet. These transactions have the potential to affect junior partners life savings or even exiting partners retirement accounts.
When checks are about to be written, the Discounted Cash Flow technique, which values the company on a historically grounded and analytically rigorous assessment of the future of the company, is the best way to value an RIA. More on that next time.
David DeVoe is managing partner and founder of DeVoe & Co., a San Francisco-based financial services consulting firm specializing in business strategy, mergers and acquisitions, succession planning and valuations for RIAs.
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