What Really Determines Your Firm's Value

by Charles Paikert

SEP 5, 2014
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.

It's not just the faster-growing firms that are fetching higher valuations. Size matters too. Firms with around $100 million in AUM are being sold at 4 to 6 times cash flow, while firms in the $500 million range are commanding multiples of 5 to 7 times cash flow. And RIAs with more than $1 billion in assets are being sold at 6 to 9 times cash flow, the most recent example being Banyan Partners, which was bought by Boston Private Bank and Trust Company for a reported 9 times cash flow.
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?"

SEC Urged to Move on Uniform Fiduciary Rule

Kenneth Corbin

 
WASHINGTON -- Advocates for stronger fiduciary rules are calling on the head of the SEC to move forward with a proposal to impose a uniform standard of care for brokers and investment advisors, even if that means pushing the rules through a divided commission split along party lines.
On a conference call to kick off what they have dubbed "Fiduciary September," supporters of a uniform standard acknowledged that there is no consensus on the issue within the SEC for what they see as a common-sense investor protection -- that financial professionals serving the retail market should dispense advice that's in the best interest of their clients.
"This should not be a partisan issue," says Barbara Roper, director of investor protection at the Consumer Federation of America.
But with Republican commissioners Daniel Gallagher and Michael Piwowar having expressed skepticism about the merits of a uniform fiduciary rule, Chairman Mary Jo White could only proceed with a 3-2 party-line vote. If that's the case, "so be it," Roper says. "The chair must be willing to take that vote."
INVESTOR CONFUSION
In remarks at a conference earlier this year, Gallagher said he was not convinced that a uniform standard would address "issues of investor confusion," or that "the costs don't outweigh the benefits."
"I'm not there yet," Gallagher said.
The SEC's consideration of a uniform fiduciary standard stems from the Dodd-Frank Act, which granted the commission the authority to write rules aligning the standards governing the brokerage and RIA sectors, but did not mandate that it do so. White has said that she feels some action is needed to address confusion among investors, who often do not know about the different standards of oversight among RIAs and advisors.
Brokers generally are only required to make recommendations deemed suitable for their retail investors, which is generally regarded as a less stringent standard than the fiduciary obligations that compel advisors to act in the best interests of their clients.
Roper warns that the convergence of the two professions has sewn confusion among investors, particularly when brokers bill themselves as advisors, but are not required to put their clients' interests before their own when making recommendations.
"As a result they are indistinguishable to the investing public. But brokers aren't advisors, at least not legally. They're salespeople," she says. "That is not what people expect -- and have every right to expect -- when they consult an investment advisor."
White has said that she has directed SEC staffers to develop a menu of options for how to proceed with any potential fiduciary rulemaking.
DoL PROPOSAL
Fiduciary advocates are also reiterating support for a separate and more controversial proceeding underway at the Department of Labor, which is considering rules to apply fiduciary responsibilities to advisors working with retirement plans.
Supporters of the DoL's fiduciary proposal argue that tighter rules to guard against conflicted advice in the IRA and 401(k) sector are long overdue in the defined-contribution era, when individuals shoulder more of the responsibility for saving and planning for retirement.
"Individuals bear the ultimate risk of getting it right or suffering real consequences for their income security in their retirement years," says David Certner, legislative counsel and legislative policy director at the AARP. "The reality is that most people lack the skills, the time, the information to make these decisions."
Critics have blasted the proposal, warning that it would regulate the commission-based model out of existence and cause advisors to abandon the retirement segment in droves, leaving millions of workers without access to much-needed advice.
The contentious proceeding at the Labor Department has sparked opposition from dozens of lawmakers and industry groups such as the Financial Services Institute. Labor has pushed back the target date for issuing its proposal to sometime early next year.
Kenneth Corbin is a Financial Planning contributing writer in Washington.
Read more:

• Failed Experiment at the SEC
• Do Independent Advisors Oppose Expected DoL Fiduciary Rule?
• Advisors Push Lawmakers on RIA Exams, Uniform Fiduciary
• Do Your Clients Trust You?