We’ve been hearing a lot of chatter recently about the extreme multiples at which M&A deals in our industry are being done. And quite often we’re asked why the Truelytics valuations don’t reflect those same multiples. In fact, we hear this question so frequently that we felt it important to offer our thoughts and provide some clarity.
The Current M&A Environment
Let’s first explore some of the reasons why deals in our space are being done at such high multiples. There are several factors at play that drive prices up to the extraordinary amounts we’ve recently seen. The first is that there is a shortage of sellers. I often joke that when speaking to a room of 100 advisors, I’ll ask who wants to be a buyer – and 99 people raise their hands (the 100th advisor has dozed off in the back corner of the room). And we frequently hear from lenders in the industry that there are 50 to 100 buyers per seller. Well, demand equals a price premium.
Second is that we now have easy and affordable access to capital. Unlike a decade ago, there are numerous lenders in the space that understand our industry and are willing to lend to borrowers at attractive rates and terms (e.g., ten-year loan terms are common). Having access to capital results in buyers feeling more comfortable with a higher purchase price – and using that leverage to outbid competitive buyers. These items, combined with our current low financing rates (not to mention pandemic-driven incentives such as payments being covered for up to six months), have led to even greater premiums being applied to purchase prices.
Additionally, many buyers realize that they aren’t just buying a business for what it is today or has been in the past; they’re buying the potential for growth. For example, when acquiring an aging advisor’s business, a buyer may recognize the opportunity to increase the wallet share of the acquired client base or attract their heirs. In other cases, they may be acquiring talent or other strategic value.
Finally, and we’ll be honest – some buyers are inexperienced. Rather than use a desired return on their investment to determine an appropriate purchase price, they simply apply some multiple that they’ve heard is a good price, perhaps not fully understanding the mechanics behind it. Others get caught up in the emotion of doing an acquisition and end up overpaying. This tends to be less common when financing a deal through a lender though (versus the seller holding a note) – many provide solid guidance and education on pricing and terms.
At the end of the day, when you back into a multiple using the purchase price (which often includes a premium) divided by the firm’s revenue, yes - it’s not uncommon to see multiples of 3x or greater. But that doesn't mean it's an accurate way to determine the value of a business.
Valuation & Approaches
A valuation helps you assign a fair value to a business as it is today based on how it has performed in recent years and to other businesses of similar size. The valuation is a starting point that allows you to proceed with confidence. It's not meant to be predictive of future results beyond what is already known of the business today.
But just because the valuation isn't a crystal ball, that doesn't mean you should dismiss it. A valuation, when calculated correctly, is an incredibly powerful tool for both buyer and seller in an advisory business M&A transaction. Not only does the valuation help you establish a starting point for negotiations, it also provides deeper insights into the strengths and weaknesses of the business. And perhaps – most importantly – it's also necessary if you hope to secure financing from any of the lenders serving the RIA and independent financial advisor M&A market.
The commonly used methods of valuation can be grouped into one of three general approaches: asset approach, income approach, and market approach.
The asset approach to valuation essentially takes the fair market value of a business’s assets and then subtracts the fair market value of its liabilities. Identifying the assets of a company can be tricky though – especially for assets that are not on the balance sheet, i.e., the intangible assets.
It goes without saying that the businesses in our industry are primarily that of “intangible goodwill” (i.e., client relationships) and it’s unusual for there to be any associated liabilities. Additionally, this approach is generally used to value a real estate or holding company and should not be used for an operating business. As such, the asset approach is not an appropriate methodology to use to value financial advisory practices.
There are two widely accepted income-based approaches: the Capitalization of Cash Flow Method and the Discounted Cash Flow Method. Both of these methodologies are used to value a company based on the amount of income the business is expected to generate in the future. Simply put, the income approach considers a business’s historical financials to make projections about future profits.
Finally, the market approach determines the value of a business by comparing it to the recent selling price of other businesses in the same industry. Pricing multiples are used to establish a reasonable selling price for the company when comparing them to the marketplace. By way of example, we commonly see market comps being used to establish the listing price of a home.
Understanding Financial Services Industry M&A
Here’s the interesting thing about deals in our industry though, so few of them are announced or made public. And if they are, it’s usually the really big deals that make the news (e.g., Goldman Sachs buying United Capital); the deal for the average advisor will rarely be made public. Even when they are publicized, the terms (including the price) remain largely unknown. That makes it nearly impossible for the market approach to be a reliable way to value a business; there’s simply not enough data to make an accurate or fair comparison.
Now, it’s widely known that there are companies in our industry that serve as deal “brokers” who maintain a database of recent transactions that they’ve facilitated. When you consider though that many of these brokers represent neither side of the transaction (or in some cases, represent both) and are compensated based upon the deal closing AND the amount of that sale, you may begin to wonder about the validity of that data. With that in mind, one may logically conclude that it could create a potential conflict of interest – are sale prices being driven up to profit the broker? We’re not suggesting the practice exists in our industry, but it is a reasonable consideration to ponder.
The Truelytics Valuation
With just two viable approaches to valuation for our industry, you may be wondering how Truelytics performs valuations.
The Truelytics platform relies solely on the income approach and specifically, the Discounted Cash Flow (DCF) method – which is used to estimate the value of an investment based on its expected future cash flows. In other words, our DCF analysis attempts to determine the value of a business today based on projections of how much profit the business will generate in the future.
Now, keep in mind, you can’t combine valuation methodologies within the methodologies themselves – you must use one or another (or average two or more methods). Therefore, it’s important to remember that the income approach does not consider or factor in market comps; they’re different methodologies. The income approach considers the future earnings potential of a company based ONLY on that company’s past (and projected) performance.
It might be helpful to think about the income approach as a measure of intrinsic or underlying value, and the market approach as one that reflects demand in the marketplace and what someone might be willing to pay based on current conditions.
I find it helpful to apply the concept of the market approach to that of the real estate market. When demand for homes is high and mortgage rates are attractive, we tend to see purchase prices rise. Similarly, when the market is down, home prices drop – think about the difference between what the housing market looked like in 2008/2009 and what it is today.
But consider that (in the short-term, at least) the underlying value of the house really doesn’t change. Nor would the county’s tax assessment immediately change on that property based solely on a recent sale price.
Think about value from the perspective of the lender too. Let’s say that I’ve listed my home for $350,000 and I have multiple bidders that have gotten into a bidding war. Because of the demand for my home, I’ve received and accepted an offer of $400,000. Naturally, my buyer needs a loan, so the mortgage company sends an appraiser to my value property. But that appraiser examines and analyses the value of my home – separate and apart from the purchase price and the market comps. It’s not uncommon to have purchase prices in an “up” real estate market far exceed that of the actual value of the property, as determined by the lender/appraiser.
In real estate, it’s easy to determine the number of bedrooms and bathrooms, and the square footage of a house. That’s not quite the case when looking at businesses – often, the standard of value being used may be unclear, as well as the details of the sold businesses. This further complicates the validity of using market comps.
This is perhaps one of the most heard phrases spoken by business owners today. Every business – every advisor – believes that they are different from the masses; that they’re unique. If that’s truly the case – then why would anyone ever want to use market comps for valuation!?
Even in ordinary manufacturing companies, the subject company is most likely different from the comparable companies in some way (size, structure, product diversification, etc.). The differences become even more extreme when you look at service companies, and are much harder to define.
Value vs. Price
With everything we’ve covered so far, the big question becomes – why are buyers paying such premiums over the income-approach valuation to acquire a business?
Oftentimes, it’s for economic and business reasons. Just look at valuations for publicly traded companies and the influence macroeconomics and market forces have on them.
Very few stocks are priced at the underlying company's book value. But understanding the book value of a company is important if you were another company thinking of buying the business. That's sort of setting the floor for your investment. It's worth at least book value. Then you factor other stuff into the equation such as business growth, sector growth, strategic value, brand value, location value, etc... and then, of course the other economic and market forces come to play.
Cheap money (low cost of capital or fast-growing market) makes it easy to digest or rationalize a higher price to get the deal done. Or increased competition may force a buyer to outbid others.
Purchase prices are going to be driven by a variety of forces that are not always tied tightly to the valuation just as stocks sometimes are priced way higher than the underlying book value and rational growth rate projections of the company.
These are difficult to quantify when looking at market comps though – you’re rarely going to know the objectives behind the buyer’s ultimate purchase price.
Value Is What It Is
That brings us back to the difference between value and price. Just because something sells for $50,000 doesn't mean it's worth that. It might be worth it to that particular buyer though….
Consider this, I can make a grilled cheese sandwich at home for roughly $2 when you factor in ingredients, cookware supplies, electricity/gas, etc. Now, I can also go to the restaurant down the street and order the exact same grilled cheese sandwich – and pay $10 for it. Has the underlying “value” of the sandwich changed? No. I’m just willing to pay more for it in the restaurant scenario. It has more “value” to me because I don’t have to shop for the ingredients, make it myself, or clean up. But when you break down the ingredients, etc. to make that sandwich, the cost is still $2.
And that’s the thing with business valuations too. Market comps are helpful to determine the price you could get under current market conditions. They reflect what someone might be willing to pay. But, more often than not, market comps reflect demand, not intrinsic value.