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6 min read

Three Traditional Approaches to Valuation Methods

Jun 17, 2021 4:01:52 PM

There are a wide variety of methods and approaches that can be used when determining the value of a financial services business. There are three business valuation methods that are commonly considered. In many instances, one of these valuation methods may suffice, but depending upon the circumstances, it can be beneficial to use a combination of these valuation methods to achieve a detailed and accurate representation of the firm’s fair market value.

business Valuation Methods and approaches

Method 1: Market-Based Valuation

The market-based valuation method utilizes technical analysis and known transaction values to determine the value of a business. This is similar to how real estate agents will assess the value of a home, using comparable homes, to determine a fair price (the market value). The challenge in the financial services industry has been that accessing this transaction data is not readily available from private transactions unless the data is aggregated by a firm who handles the transaction and provides valuation services.

Given that no two practices are exactly the same, adjustments must be made in the assessment to account for the differences between them. A market-based valuation can be particularly beneficial in a number of scenarios, most commonly when working toward setting an offer or asking price within a prospective business deal. It can also be helpful when negotiating buyouts and in some cases can be necessary to demonstrate the value of a company to tax authorities or within legal disputes.

The factors used to determine the market value of a Registered Investment Advisor, IBD advisor, tax practice, or agent/agency practice are numerous, but the most important factors include the total revenue, percentage of recurring revenue, growth rate, age of clients and average account sizes, location, client service model, and profitability. The use of a market-based valuation is at its best when there is accessible and relevant data available for the comparable entities, and there are enough similar businesses to compare it to. When data is limited or not publicly available, it will likely be better to pursue alternate valuation methods, or partner with a firm like SRG that specializes in assessing that particular market.

Key advantages of a market approach to business valuation include:

  • By comparing businesses in an “apples to apples,” the valuation result is grounded in reality since the value is determined using current transactions of similar firms, and value comparisons are easy to understand and can be highly useful in terms of providing the user with actionable information.
  • There is very little reliance on forecasts of revenue, expenses, and cash flows, or the numerous other assumptions involved in an income based valuation for example. The market approach instead takes actual data from a comparable company to help inform the value of a specific business.
  • It is flexible in that adjustments can be made to account for differences in parameters such as size or quality.
  • By using actual transaction data of comparable advisors/agents/accountants that have sold, the valuation can also include deal specific considerations, such as expected payment terms.

Key downsides to the market approach include:

  • Within some industries or scenarios, relevant comparable companies may be unavailable, or too few to serve as a reliable sample set. Especially when dealing with private companies, it can be difficult to find sufficient market data to inform a valuation.
  • Data must also be carefully selected and analyzed to present an accurate comparison.

Learn How SRG Helps Financial Firms Determine Market Value

Method 2: Income-based Valuation

The income approach prioritizes the earning capacity of a company to inform its fair market value. Within this company valuation method, a business’s past, current, and anticipated future cash flows will be analyzed to determine its value and an expected return on the investment moving forward. Various methods to generate income valuations can be implemented, including:

Capitalization of Earnings / Cash Flows Method

This income-oriented approach is used to determine a business valuation based on its future estimated benefits. This estimation is typically calculated based on the earnings or cash flow for the given business. The estimated future benefits are then leveraged in a capitalization rate to determine a businesses rate of return. This method is most appropriate for mature and stable businesses that can reasonably expect future incomes to grow at a constant rate.

Discounted Cash Flow Method

The Discounted Cash Flow (DCF) Method is used to estimate the value of an investment based on its expected cash flows, looking at the operating cash flow, discretionary cash flow, or after-tax cash flow. By using the DCF method to create future projections on how much money the business may generate, it can inform the investment’s current market value. This method is best suited for companies that have a lack of earnings history or have uneven growth in their future benefit streams.

Excess Earnings Valuation Methodology

The excess earnings method is often described as a hybrid method, as it references both the company’s asset values in addition to discounting expected cash flows. This simple approach discounts company earnings by leveraging data from two capitalization rates: a rate attributable to company goodwill (intangible assets) and a rate of return on tangible assets. This method is preferred when assessing the value of financially sound, large businesses with significant amounts of goodwill. The excess earnings method can also be used within an asset-based valuation approach (which we will also discuss later on).

 business Valuation Methods

Key advantages of an income approach to business valuation include:
  • Income-based valuation methods are widely recognized and helpful in giving a sense of future earning potential. Since the market value of a company is often viewed as the present value of its future cash flow or earnings, this method can be instrumental in demonstrating the true value of a company.
  • Even if there is no active market for the given business, a market price can be simulated by using accessible income data.
  • An income approach is considered to be generally flexible for assessing the value of a business, regardless of the stage it is in as a company.
Key downsides to the income-based approach include:
  • There is inherent risk with projecting future cash flows as it is not an exact science and variables can change the trajectory of a business and their earning potential. This reliance on hypothetical projections has the potential to be inaccurate.
  • Income-based approaches assume that the current cost structure of the firm will be retained by a buyer, and for many advisors/accountants/agents, a buyer will only value and acquire the revenue and clients, making the seller’s ability to generate profits less relevant to the exercise.
  • The process is highly subjective. Discount rates that are utilized for example have many variables, and determining an appropriate figure is subjective based on the expertise of the valuator. The combination of assumptions, if each is off slightly, can have a compounding effect and render the valuation unreliable.

Your Guide to Increase the Value of Your Business

Method 3: Asset-Based Valuation

Similar companies can also be compared through an asset-based valuation. An asset-based valuation shifts the focus to the net value of assets within a company or the fair market value of the company’s total assets (after deducting its liabilities). Through this exercise, asset valuation can help illustrate the cost of recreating a similar business by highlighting the assets needed for operating a similar company. Along with the aforementioned excess earnings method, the asset accumulation valuation method is commonly used within the framework of asset-based valuation. However, for financial service firms and other similar professional service companies, asset-based valuations are not used due to the fact that they have very few tangible assets and derive their value from goodwill and cash flow.

Experts Make Choosing the Best Valuation Methodology Easier

While there are many different methods of valuation available, these three valuation methods are the most common, and the income and market-based methods are the methods used for financial service businesses (and most other professional service companies). Because each company’s situation is unique, the approach to determining the value of the business is not uniform across all companies. In fact, the data presented through a valuation analysis should be assessed with the context of a specific business and its role within the industry in mind. Arriving at an accurate valuation may also require using multiple methods to represent a business's value accurately.

While this can be a daunting undertaking for a business, working with industry professionals to manage the process can help ensure accurate and thorough results. Succession Resource Group provides the most comprehensive valuation services in the financial industry and has decades of expertise in the field, having valued hundreds of businesses in just the last 12 months. If you are buying, selling, or planning the sale of your business, we can help complete your project efficiently and cost-effectively. Please contact us today for an initial consultation and let us help guide you through the valuation process.

Topics: Valuation
David Grau Jr.

Written by David Grau Jr.

David Grau Jr., founder and CEO of Succession Resource Group, specializes in succession and M&A consulting for advisors. As a leading M&A consultant with a history of service in the United States Navy, David is recognized as a thought leader and accomplished speaker. He is prominent in the financial services industry, especially on topics related to M&A and next-generation strategies, having delivered over 200 presentations for organizations like the Financial Services Institute (FSI) and FPA.