“Coach’s Forum” is a place in which you can ask your questions, tell your stories or give your opinions on any aspect of practice management. For each column, George selects the most interesting and relevant comments from readers and offers his advice. Our objective is to build a community of people with a common interest in making their financial advisory practices as effective as possible.
Advisor says: I am in discussions with a younger advisor in my office about taking over my practice in five years’ time, when I will have been in the business for 35 years. One big point of contention is the value of my business.
My firm has a suggested valuation formula based on assets under management (AUM), so we ran the numbers and came up with a value that I thought was pretty low. I was approached last year by one of the bank-owned firms, which proposed a formula based on previous years’ average revenue. Their valuation was significantly higher.
Can you add depth to the subject of valuation?
Coach says: Practice valuation is such an important and broad topic that it warrants significant expansion on the comments I made in last month’s column. At that time, I identified how the basic principles of valuation apply in the real world of financial advisors buying and selling practices or books of business.
To recap, those principles are:
1. Future profitability determines current value.
2. Cash flow is king.
3. There is a risk/reward trade-off.
4. Practice valuation is both a science and an art.
5. The final sale price will depend on the individual motivations of the buyer and seller to complete a deal.
Within the context of these five principles, let me walk you through the process we at Market Logics Inc. follow in determining an appropriate price range for an advisory practice. I have included an example of the calculation. The steps are:
– Step 1: Analyze the income statement
When we ask advisors for their income statements, many will hand us their income tax returns, which have been prepared specifically to show the lowest amount of profitability in the business so that the least amount of taxes is owing. When we are valuing a business for sale purposes, however, we want to show the most profitability we can to increase the practice’s price. Consequently, we often have to “normalize” the profit and loss statement by adjusting for unusual cash flows in and out, family on the payroll, personal expenses paid by the business, etc.
– Step 2: Determine discretionary cash flow
Most advisors do not differentiate between the compensation they receive for performing their advisor duties and for their ownership of the business. We allocate a portion of total advisor income to direct costs of operating the practice, by asking, “What would we have to pay someone to carry out the advisor role?”
The balance of the advisor’s income represents profit or discretionary cash flow.
– Step 3: Calculate the discount rate
The expected future discretionary cash flow has to be converted to its present lump-sum value to account for the fact that this cash flow will be received over time and that there is some risk that it will not materialize every year as calculated.
Back in Investment 101 at school, we learned that there are two kinds of risk associated with investing in equities. The first is the risk inherent in the market itself; the second is the risk of investing in a specific company.
Market risk is derived from the risk-free rate of return (of, for example, government bonds); plus an equities risk premium (of, for example, the Toronto Stock Exchange’s returns) in excess of the risk-free rate; plus an allowance for the risk of investing in “micro-micro-micro-cap” advisory practices.
Specific risk is derived from an assessment of productivity, profitability and a number of qualitative factors that make one practice worth more or less than another practice of equal size.
Market risk + specific risk = discount rate.
– Step 4: Estimate the growth rate
Simply applying the discount rate to discretionary cash flow would be inaccurate without allowing for future growth of the practice due to business development or market gains. High rates of growth generally are unsustainable over time, so we assign a conservative growth assumption to account for market volatility and fluctuating revenue.
– Step 5: Calculate the capitalization rate
The rate at which we capitalize discretionary cash flow to bring it to its present value is the discount rate minus the growth rate.
– Step 6: Calculate the range of values
The range of practice values is determined by dividing the discretionary cash flow by the capitalization rate.
– Step 7: Calculate ratios
Investors always are interested in ratios, such as price/earnings. We also calculate industry ratios, including a multiple of revenue and the percentage of AUM.
The range of valuations accounts for some of the subjectivity that goes into determining the discount rate. That range also provides scope for the buyer and seller to negotiate.
The price for the practice should be at the high end of the range if something special will allow the practice to outperform other comparable businesses. The price should be at the low end of the range if revenue is likely to decline significantly as a result of the original advisor’s departure.
With all respect to my accountant and business valuator friends, this subjective assessment is why someone with deep industry knowledge is necessary in the process of gauging a realistic range of practice values properly.
Remember, however, that the final price will be determined by the vendor’s wish to sell and the purchaser’s desire to buy.
For more on practice valuation, see “The art and science of valuation” in the December 2016 issue of Investment Executive.
George Hartman is CEO of Market Logics Inc. in Toronto. Send questions and comments regarding this column to email@example.com. George’s practice-management videos can be viewed on www.investmentexecutive.com.
A sample calculation of a practice valuation
AUM = $100 million
Revenue = $800,000
Discretionary cash flow = $250,000
Discount rate = 22%-26%, calculated using:
– Market risk = 10%
– Risk-free rate @ 1%
– Equity risk premium @ 6%
– Micro-cap premium @ 3%
– Specific practice risk = 12%-16%
– Quantitative @ 4%-6%
– Qualitative @ 8%-10%
Capitalization rate = 16%-20%, calculated using:
– Discount rate @ 22%-26%
– Minus the growth rate @ 6%
Valuation = $1,250,000-$1,562,500, calculated as:
– High = $250,000 : 16% = $1,562,500
– Low = $250,000 : 20% = $1,250,000
Industry ratios used:
– P/E = 5.0-6.2
– Multiple of revenue = 1.6-2.0
– % of AUM = 1.3-1.6
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