SEP 5, 2014
11:16am ET
11:16am ET
Thinking about selling your advisory firm or valuing it for succession planning? Think discounted cash flow.
"The future cash flow - essentially the profitability - of an acquired company pays back an investor on their investment," explains valuation expert and strategic consultant David DeVoe. "The best way to value a company is to determine what those future cash flows will be."
For advisors, discounted cash flow, or DCF, is indispensible because it forecasts a company’s future cash flows by making assumptions about the growth of assets under management and revenue, as well as the likely expenses. Those series of future cash flows are then discounted back to their present value.
As DeVoe stressed throughout his recent webinar Valuing Your Firm for Succession Planning, DCF looks at the cash a company earns, and, "at the end of the day, cash-flow [representing profitability] is the most important metric for a business owner or investor."
So how can advisors do a DCF analysis and improve their valuations?
1. Review five years of historical economic information to understand the trends and growth, expenses, profitability and other key metrics, DeVoe says.
2. Forecast the company's economic future. Methodically work through potentially hundreds of line items, making assumptions regarding what will happen in the future. Five years is a standard forecasting horizon. The key outcome of this process is a calculation of expected cash flows for the next five years or more.
3. Determine a 'terminal value' which is essentially what rate the final year cash flow figure will grow in perpetuity.
4. Determine an appropriate discount rate, based on the amount of risk associated with this company and the investment
5. Mathematically discount cash flows and terminal value back to present day using the discount rate developed in Step 3, thereby creating a valuation of the company.
To improve their valuation, says DeVoe, the founder and managing partner of San Francisco-based DeVoe & Company, firms should:
- Increase Growth. "Create a sustainable growth machine. In the best case, it is implementing a comprehensive growth strategy that adds new clients, as well as an excellent client service model that retains current clients and assets.
- Increase Cash flow (profitability). A well-managed firm that is efficient, leverages technology, and trains, engages and develops their employees will have higher profit margins.
- Mitigate Risk. Running an industrial-strength organization that has intelligent processes in place and has been thoughtful about addressing potential risks will endure over the long-term and be more attractive to investors.
AVOID OLD FORMULAS
Beware of valuations using book-value or multiples of revenue or cash flow for a thorough valuation, DeVoe warns. (Deal structure can also vary dramatically and influence valuations, he adds.)
Book value is essentially the value of all the 'hard assets' within a company. "If you are valuing a company with lots of machinery, inventory, real estate, etc. which could be sold on the open market, then it might be more appropriate," DeVoe says. "But the 'hard assets' of an RIA are a number of desks, computers, chairs, etc. They add up to tens of thousands of dollars' worth of assets, though the firm can be worth millions."
A multiple of revenue is "inaccurate and dangerous because it doesn't take any expenses or profitability into the equation," according to DeVoe.
He cites two identical firms as an example. One requires three more employees than the other: it runs so inefficiently that it requires another $300,000 in personnel expenses. "Would you pay the same amount for both firms?" DeVoe says. "According to a multiple of revenue, you would, despite the fact that one firm will throw off $300,000 in profit each year."
Multiples of cash flow are closer to reality but still don't account for the growth or risk associated with the firm, or many other variables, DeVoe points out. Multiples of cash flow, such as those cited in the Banyan deal, are industry shorthand for dividing the final valuation by the most recent years' earnings.
"Advisors should be realistic," he cautions. "Do you really want to value your largest personal asset with math that a nine-year-old child can do in their head? Does this seem like the right way to make a critical decision impacting your life, business and finances?"