The trouble with 2x revenue
At some point, you’ve probably wondered what your financial advisory business is worth. As more advisors prepare for their own retirement and plan an exit strategy, having information on valuation is becoming more important. Whether you are planning to sell your business to an outside party, thinking of implementing an internal succession plan to transfer ownership to the next generation, or considering the strategic acquisition of another wealth management firm, an understanding of the true drivers of valuation is critical.
The simplest and most common approach to valuing a financial advisory firm is typically “two times last year’s gross revenue.” Under this rule of thumb, a business that generated $500,000 in revenue last year is worth $1 million dollars.
If only it was that simple. Unfortunately, in most cases this logic is faulty on two levels. Let’s look at each weakness in turn.
1. The “revenue” approach doesn’t take into account the quality of the business
Put yourself in the potential buyer’s shoes and consider two businesses that generated $500,000 in revenue last year. Which would you rather own?
The 2x revenue approach values both firms at $1 million. However, it is quite clear that owning Firm B is more desirable for the following reasons:
- It has a smaller number of large clients, which is typically easier to manage and requires fewer resources to service than a business that has 10 times the number of clients.
- It has younger clients in accumulation phase, which will oftentimes generate more revenue than a business with older clients in decumulation.
- Fee-based revenue is usually more predictable. A multiple-based approach cannot capture things like firm profitability, effort to service and retain clients and growth potential of the current book.
2. The “2x revenue” approach measures the past instead of the future
Buyers evaluate firms based on the businesses’ potential. Of course, historical track record and current state matter. But, a buyer cannot gain from what has been achieved in the past.
So, we think the appropriate way to value a business from a buyer’s perspective is to focus on future profitability and discount those profits to the present. Put another way, Enterprise Value = the Present Value of Future Profits.1
But, what drives enterprise value? Three things:
- Current profitability: The amount of money left over after all compensation and overhead expenses are paid, including the salary an advisor pays himself.
- Sources of growth: The amount of increase in profits that is reasonable to expect in future years. This is highly dependent on capital markets assumptions, ability to acquire new client households and the growth potential of the current book of clients.
- Profit sustainability: An objective assessment of the riskiness of future profits – essentially, a “discount rate” that can be used to measure future profits in today’s dollars. It encompasses aspects such as vulnerable client relationships, the level of client turnover, the level of fee-based business, clients’ affinity to the firm rather than to a key-individual, and the level of “institutionalization” of the firm.
In mathematical terms, the discounted cash flow model using the three EV drivers looks like this:
In future blog posts, we’ll dive deeper into each of the three drivers of enterprise valuation, the ways to consider measuring and tracking them and the importance of how the transfer of ownership is structured.
1 Enterprise value is the present value of future after-tax profits minus the market value of debt. For the purpose of this description, we assume no debt is held on the balance sheet.