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Why a Discounted Cash Flow Valuation is a More Accurate Measure for Valuing Your Practice

Terry Mullen
Jan 5, 2017

As the owner of a financial planning or wealth management firm, you always stress the importance of diversification and smart asset allocation to your clients. You work hard to make sure the investors you work with are not over-weighted in any one asset class, and you reinforce the intelligence of strategically rebalancing between stocks, bonds, cash, real estate and other parts of the market. You strive to make every client's financial dreams come true, from providing a college education for their kids to creating a solid retirement plan for themselves.

When it comes to planning for your future, you need to work just as hard. You need to apply those time-tested strategies and follow the same sound advice you give your clients. That means balancing all of your investments, from the stock portfolio you have so carefully created to the equity you have built up in your firm over the years.

Why Establishing a Fair Market Value is Important

Many small business owners, including the owners of financial planning and wealth management companies, make a critical mistake in their plans for the future. They focus so much, and work so hard, on building up the value of their small businesses that they neglect their other investments. As a result, they end up seriously over-weighted and overly invested in the firms they run.

This over-weighting in the business and its future creates real risks for the owners of financial planning and wealth management practices. Even business owners who have considerable outside investments often find that the bulk of their wealth is tied up in the firms they run.

The only way to determine the extent of the problem is with a thorough evaluation of the business itself. Until they know what the business would be worth to a potential buyer, it will be impossible to calculate their current asset allocation.

Establishing a fair market value is essential for the owners of all financial planning and wealth management firms, even owners who have no immediate plans to sell. And while there are many ways to value a financial planning or wealth management firm, the discounted cash flow method is usually the most appropriate.

How Discounted Cash Flow Valuation Works

The subject of discounted cash flow valuation can get pretty complicated, but developing a basic understanding of the method is relatively easy. In its simplest terms, the discounted cash flow (DCF) method seeks to determine the current value of a business, based on projections of how much the firm stands to make in the future.

Since the DCF valuation method uses future projections, there is bound to be some element of uncertainty. Despite those limitations, however, the discounted cash flow method is typically the best way to put a fair market value on a financial planning or wealth management firm.

According to the discounted cash flow valuation method, the value of the financial planning or wealth management firm would be equal to the total amount of all the money it would be able to make available to its investors in the future. The discounted part of the DCF valuation analysis comes into play because the future value of that current cash flow will be less than its value today. The erosive impact of inflation means that a dollar of earnings at some future date will be worth less than a dollar earned today.  It also includes adjustments for risks that could impact that cash flow based on your firm’s business stability, client stability and market stability.   

Some of the factors that are considered include; AUM, business continuity plans, non-compete agreements with key employees, average client age, mix of revenue sources, relationship with the next generation and future projected growth rates.  These factors and others, will impact the attractiveness and value a potential buyer is willing to pay. Having a clear understanding of the gaps today will allow you as the owner to know what you need to do to improve and maximize the value in the future.

A Practical Example

The subject of discounted cash flow analysis and valuation can be pretty complicated, and it is easy to get lost in the weeds. That is why it 's nice to have a real-world example that illustrates how the DCF valuation works, and why it is the best way to accurately value a financial planning or wealth management firm.

For purposes of illustration, let us assume that the wealth management firm in question is expected to earn $100,000 in the coming year. Under a discounted cash flow valuation analysis, the value of that $100,000 in today's dollars would have a greater value than the same $100,000 of earnings in the future. To complete the discounted cash flow analysis, the valuation specialist would perform the same sort of calculation on all future earning years, thus arriving at a fair valuation for the business as a whole.

Advantages of the Discounted Cash Flow Valuation Model

The discounted cash flow (DCF) valuation model has some distinct benefits for the owners of financial planning and wealth management firms. One of the most significant advantages of the DCF valuation model is that it returns the closest thing private practices can get to an intrinsic stock market value. By valuing the business based on the discounted value of future cash flow, valuation experts can arrive at a fair market value.

Having that fair market established by an independent analysis can make future sales easier, but there is another huge advantage. Since many business owners have a significant portion of their wealth tied up in the firm, an independent DCF analysis will make it easier to determine their real asset allocation.

The discounted cash flow valuation method is also a useful reality check for the owners of financial planning and wealth management firm. It is one thing to guess at the value of the business you have worked so hard to build. It is quite another to conduct a formal analysis and arrive at an accurate market value for the firm. Going through this exercise can be helpful for everything from future growth plans and anticipated borrowing costs to estate planning and tax considerations.

Even if you have no plans to sell your business, it is a good idea to conduct a thorough evaluation of your firm and its actual market value. The discounted cash flow (DCF) valuation method provides some significant advantages, giving the owners of financial planning firms a unique insight into the value of their firms and the state of their own wealth management.

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