The right (and wrong) way to think about profitability

Enterprise profitability chart

From a valuation perspective, which of these two advisory firms do you think could command the higher number in the sale of the business?

Ev2 post chart

At first glance, one might be tempted to value Advisory Firm B higher. After all, it is twice the size of Firm A in terms of AUM and it generates 40% more revenue. But, with a 20% profit margin, Advisory Firm A is actually more profitable (i.e. has more money left over after all compensation and overhead expenses are paid) – and, all else being equal, would likely command a higher enterprise value.

We believe that profitability is among the most important measures of success of a business and its ultimate value. In past posts, we have discussed the three main drivers of enterprise value, or the value of a financial advisory business, which are:

  • 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.

When it comes to assessing profitability in the case of Firm A and Firm B, it’s not that AUM or revenue don’t  matter. But think about it this way: if you were transitioning the ownership of your business, the new owner would be entitled to a percentage of future profits the business will generate – not of past gross revenue. In simple terms, a business can’t have value without having profits.

Curious about calculating your own firm’s profitability? Consider the “40-40-20 rule.”  

To help calculate your firm’s profitability, start with your gross revenue for last calendar year − that’s all of the dollars that your business generated over the course of a year. Then subtract expenses separated into two categories: advisor compensation and overhead expenses. In order to benchmark your profitability, consider this rule of thumb: approximately 40% of gross revenue should be attributed to advisor compensation (more on that below), and another 40% to overhead expenses, which includes cost of doing business with your broker dealer, if applicable. The amount leftover is your profitability.

Chart 2

Remember that if you are an owner of your advisory firm, you have two sources of income stemming from two roles you play in the business:

  1. Your role as owner, for which you’re compensated by your share of the firm’s profits (100% share if you’re the sole owner)
  2. Your role as a financial advisor/employee of the firm, for which you’re compensated by a salary (think of this as how much you as an owner would have to pay a financial advisor to do your job)

Strategies to help increase profitability

So now that you have a clearer picture of your firm’s profitability, what might you do to improve that profitability and your enterprise value? We believe there are a few keys to success:

– Measure profitability regularly. Without a good understanding of your firm’s profitability, it can be hard to improve your profitability and hence your firm’s enterprise value. If you are the owner of your business, consider paying yourself a fixed salary to separate your income as an owner from your compensation as a financial advisor. An awareness of your firm’s profitability and a sharp focus on improving it tends to lead to improvement.

 Look at your fee levels. Ensure they are in line with the level of service you offer. Consider building a tiered service (and fee) model – and sticking to it. Resist the temptation to offer a discounted fee schedule to clients with a larger asset base, or offer a disproportionate amount of service (time and effort) to lower-revenue clients. Instead, charge a fee that fairly represents the level of service required for high revenue versus low revenue clients.

– Manage your costs. If your compensation and other expenses are far out of line with the 40-40-20 rule of thumb, consider realignment.

The bottom line

Although assets under management and revenue typically get a lot of attention when describing advisory firms, when it comes to calculating enterprise value, profitability typically is where it all begins. Calculate the profitability of your firm and see how it compares to the “40-40-20” rule of thumb. If it’s far out of line with this estimate, consider making adjustments. Measure your profitability regularly and consider using it as a guide when making strategic business decisions.

Check back in the coming months as we explore the remaining drivers of enterprise value: sources of growth and profit sustainability.

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