My last IFA contribution (September 2014) looked at external factors that impact industry valuations. I skirted the elephant in the room – that is, the application of recurring revenue and/or EBIT and the more controversial question of why accounting firms trade at one times and financial planning practices trade at three times.
It is time for me to step into the breach and address the issue. The other matter that is of interest to readers is how to achieve a premium to market average and I hope to profile key determinants to value assessment.
The most widely accepted financial planning industry-specific methodology is that of recurring revenue, though this has recently been theoretically challenged by the use of earnings before interest and taxation (EBIT) or capitalisation of normalised future maintainable earnings/cash flow. Some also advocate the little-seen discounted cash flow analysis methodology.
As Morris Kaplan of the International Association of Consultants, Valuators and Analysts (IACVA) comments:
The Income approach is the most used in the SME sector because it is easier to use than the other approaches. Valuers can estimate value from actual financial results, although many assumptions have to be made, including business growth, risks applicable and economic factors in arriving at a conclusion.
The Capitalization of Future Maintainable Earnings, which is determined by normalizing the earnings or cash flows, is most common although where the circumstances permit, a Discounted Cash Flow (DCF) methodology, which is a more detailed forward-looking view of a business, can be applied.
The DCF methodology, whilst involving a significant use of assumptions into the future and arguably very much ‘art’-oriented, requires the systems, budgets and cash flow analysis to be in place, which is often not the case with smaller businesses.
Maintainable earnings is the pervasive methodology for accounting practices. I am not going to challenge the appropriateness of the alternative methodologies but focus on the commonality of each methodology in regards to risk assessment.
Any methodology must take into account the risk to the revenue or profitability of a business and adjust or discount accordingly. This is where valuations move from science to art as there is significant room for subjectivity. There are three filters that are looked at when assessing risk:
- External factors mentioned above but also general economy and industry-specific factors, current and expected;
- Internal factors as nominated by Morris Kaplan, “which are relevant to the business being valued, such as size and company-specific factors, including business stability, key person reliance, competition and other considerations need to be quantified. This is where a valuer’s experience and understanding of the business and industry are important. There are commonly accepted methodologies that are used to calculate this risk, although a lot of this requires the valuer’s subjective judgement of the relevant factors”; and
- Investment factors – risk associated with the investment itself, expected capital return, liquidity and return on equity.
Business owners need to have an active awareness of what the internal factors are and how they can influence and impact business value. Internal factors include:
- History, track record and reputation of the business, principal/s and staff;
- Financial performance, stability and viability;
- Strategic and commercial acumen of the principal/s;
- Scope and size of the business, ie funds under management (FUM), number of clients, type of clients, product composition, average FUM per client, platforms, pricing model, range of products and client service offering;
- Client segmentation and age demographics;
- Growth opportunities, the strength of alliances, referral sources, client retention and cross-selling opportunities;
- Marketing plans, strategies and growth plans;
- Advice offering, ie advice model or product sale business;
- Client profitability, overall profitability of the business, consistency of ongoing revenues;
- Compliance performance;
- Complaints, PI claims, client retention, client satisfaction surveys;
- Product risk, such as tax-effective or private investment syndicates (additionally, exposure to declining assets such as allocation pensions, etc);
- Financial stability; and
- Client segmentation and profitability, overall profitability of the business, consistency of ongoing revenues.
A valuation cannot just focus on financial performance, and a large part is the subjective assessment of the quality of management – what legacy has been left, what key person dependency or client dependency is inherent within the business, and how strong is the revenue.
Management performance is benchmarked in a number of ways – accounts receivable, accounts payable, employee turnover (an important identifier to culture), workflow processes, templating, management reporting and monitoring, cash flow management, brand development, adoption of innovation, and corporatised offer, ie the delivery of advice is not the domain of one and the client enjoys multiple internal relationships and the loyalty is to the brand, not the individual.
An example of the impact of the above influences can be seen in the significant value differential between the advice or wealth management industry and accounting practices. As a rule of thumb, accounting practices generally attract 0.6 (income annual returns low margin, high volume, low client contact/loyalty) to 1.0 times maintainable income, and financial planning attracts 3 times recurring revenue.
The key differences that create these substantial valuation gaps are that accounting practices are normally deemed to be inferior businesses in risk terms due to their pricing models, ie hourly rates. Their income is inhibited by the number of hours in the day or their number of personnel; exposure to bad debts; debtor days being greater than 30, 60 and sometimes 90 days; the practice of write downs – not getting time recovery due to customer price sensitivity and misappropriation of resources; reliance on the principal (key person risk); and inability to access the same economies of scale due to the level of personal exertion needed to produce an output.
Therefore margins are less than those of financial planning practices in most cases, thus the different methodologies and multiples applied.
A planning business will rarely have bad debts. With monthly client account deductions, its income is largely, not solely, derived from personal time invested, and a book of business or rights to revenue can be acquired without necessarily the acquisition of personnel and the existing cost structure. Revenue will continue and therefore scale benefits are more easily achieved.
The greatest risk to the enterprise value of a financial planning business is compliance.
The reason recurring revenue is used is that it is of little materiality how profitable the financial planning business was prior to acquisition if the business is to be ‘bolted on’ or dropped into existing infrastructure, where the previous cost structure of leases, personnel etc are not going to be ongoing and economies of scale are going to be significant (enhanced volume overrides, reduced dealer fees etc).
It is maintenance of revenue and the merged entities’ profitability that is paramount.
This pricing gap between the two disciplines may close in future years as cloud and other technologies are embraced, outsourcing solutions are adopted by accounting practices, and margin improvement is reflected in higher multiples being applied. If financial planning moves to hourly fees or synergy/scale benefits are diminished (eg volume overrides) this could drive multiples lower than those being currently enjoyed.
Outsourcing solutions are no longer the domain of large corporates, and with the evolution of cloud technology access, time zones and security are less of an issue and access to trained skilled labour who are retained and included as part of the domestic team is the key determinant of success.
Outsourcing has reached a tipping point and is now a viable strategy to improve margins, retain profitability and maximise business enterprise value. This will be a trend that impacts all disciplines and industry participants and will assist in asset value maintenance and improvement.
When valuing a business, a number of methodologies may be employed, using multiple qualitative and quantitative analysis, but an additional filter is to utilise the market approach – overlaying recent similar sales ( similar size, location, type etc) to ensure market relativity.
This is difficult for most as this information is normally closely held. Therefore, using a third party to identify risk and assess real value is important in regards to the most fundamental question of what is a business worth.