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.
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:
Key downsides to the market approach include:
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:
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.
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.
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).
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.
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.