The Retail Distribution Review (RDR) has had a significant impact on the way consumers buy financial services.
The shift in the way that commission is charged has meant that the strategies of many advisory businesses have had to change in order to come to terms with this new reality.
However, for many businesses, the cost of change both in terms of time and resource has forced some owners to consider their position. As businesses have started to consolidate to achieve economies of scale, the question on many advisory firm owners’ lips is: what is my business worth?
Essentially, the market value of any business is the price at which a willing buyer will transact with a willing seller. Determining this value is a perennial question for CEOs and owners of advisory companies.
Valuation experts are often engaged to apply their analysis, experience and judgement to derive a value estimate for a particular business. Given the uncertainty of future prospects for a business, opinions may differ between valuation experts.
The extent to which they differ will depend on the quality of information available in determining the key inputs to the valuation.
For large, mature businesses in the advisory space, where there are lots of similar competitors, it may be possible to benchmark indicators of value to the target business in question using market pricing information (either from a listed comparable company or private transaction information).
Also, it may be possible to use the past performance of the target business, particularly financial returns, as a yardstick of expected performance in the future.
However, for small and early-stage businesses in the advisory space, information is likely to be scarcer and the valuation assumptions required more subjective.
Ultimately, there are a number of ways a business can be valued. These include, among others: discounted cash flow, multiples, asset and real options approaches. Depending on the circumstance, information and context, each methodology has its advantages and disadvantages. Certain approaches may not be appropriate in specific circumstances and no method is bullet-proof.
Given the relatively low level of tangible assets in advisory businesses, two of the most popular methods are the discounted cash flow and multiples approaches, which are often used to value companies in this sector.
Discounted cash flow
The discounted cash flow approach establishes the market value of a business by calculating the free cash the business will generate in the future and discount back to today.
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This approach requires the use of a credible forecast, which captures all elements that comprise the free cash flows of the business (revenues, direct costs, operating costs, marketing costs, working capital, tax, etc.).
For the valuation of advisory companies, forecasts should be underpinned by a commercial rationale. For example, where possible, the forecast should reflect considerations such as:
• The business contacts within the local market and strength of customer relationships;
• The size of the total market now (whether local, regional or national, depending on the scale of the business) and expected growth in the market over time;
• Sensitivities to external factors (e.g. merger and acquisition market or regulatory changes) which will influence the size of the market;
• The expected market penetration in the given locality and the people and marketing costs required to achieve the projected market share;
• The earnings margins generated historically and by competitor companies;
• The concentration of competitors in the market now and in the future.
Of course, there are many other considerations, which will vary depending on the context.
In addition, free cash flows beyond the forecast period also need to be calculated. This is typically performed by calculation of a ‘terminal value’, which captures the longer term cash flow prospects.
The terminal value also needs to be consistent with future recruitment, marketing, the scale of the market and competition.
Since discounting forecast cash flows is required to compensate an investor for the risks of their investment, the credibility of management is also a key factor and will often be captured in the discount rate applied.
In addition, there may be key employees who generate a large proportion of the business due to their contacts and customer relationships and without whom the business would struggle.
The risk of losing key employees may be more pertinent for small advisory companies than their larger equivalents and might need to be factored into the discount rate.
Where companies are reliant on a small number of customers for their business there may be greater perceived risk, which would also need to be reflected using a higher discount rate.
Another way of valuing a business is by applying a ‘multiple’ taken from a comparator company or peer group with observable market pricing (e.g. quoted share price or a completed transaction) to a metric of the target business.
Multiples normally take the form of a ratio of market value to earnings estimates (e.g. enterprise value / EBITDA or share price / EPS) but can also be a ratio of market value to an industry specific measure; for example, the valuation of asset managers are often referenced to the size of assets under management, since they are a key value driver for these businesses.
The choice of multiple metric and the comparators are crucial for this approach. For example, early-stage companies are unlikely to be generating high positive earnings so earnings multiples may not be appropriate.
Further, even if they do generate positive earnings, if the growth profile of earnings is much higher than the comparators, then using comparator multiples may undervalue the business.
It is paramount to ensure that differences in earnings growth profile, earnings accounting treatment, stage of development, size and risk between the comparators and the target business are fully considered.
There is no ‘one-size fits all’ approach to valuation and it is important to be aware of the pitfalls. Try as best as possible to understand the business and the limitations of the valuation approach being applied.
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