With these factors in mind, let's explore the three most common methods used to value a wealth management practice.
Multiple of Revenue
One of the simplest methods to value a wealth management firm relies on a multiple of revenue. This multiple is often applied to Trailing 12-month (TTM) revenue but may be applied using a 3-year average, quarterly annualized, and projected 12-month revenue.
The actual multiple applied to determine the value of the practice depends on how the revenue is generated. In general, a higher multiple is placed on recurring revenue (fee-based), and a lower multiple is placed on the portion of revenue that is transaction-based. The resulting values are added together to determine the total value of the advisory firm.
One problem with a revenue multiple is that it fails to consider other aspects of the wealth management firm that make it unique compared to its peers. Consider the following example:
| RIA 1 | RIA 2 | |
|---|---|---|
| Revenue | $5,000,000 | $5,000,000 |
| Multiple | 2.3x | 2.3x |
| Valuation | $11,500,000 | $11,500,000 |
| Revenue | $5,000,000 | $5,000,000 |
| Expenses | ($4,000,000) | ($3,000,000) |
| Profit | $1,000,000 | $2,000,000 |
| Profit Margin | 20% | 40% |
Since both RIAs have the same revenue, we would value each advisory practice the same if we relied solely on a revenue multiple. But a quick look under the hood would reveal different expense structures, resulting in different profitability.
Multiple of EBITDA
EBITDA stands for earnings before interest, taxes, depreciation, and amortization. It is a measure of earnings that eliminates financing costs (interest), non-cash expenses (depreciation & amortization), and taxes. It is often used to evaluate a financial firm's operational performance because it removes the impact of the management decisions mentioned above. Many of the earnings-based multiples you see for RIAs are based on EBITDA.
While an earnings-based multiple is oftenmoreaccurate than a revenue multiple, it still fails to accurately assess all of the unique aspects of a wealth management firm. Consider the following example:
| RIA 1 | RIA 2 | |
|---|---|---|
| Revenue | $5,000,000 | $5,000,000 |
| Expenses | $3,500,000 | $3,500,000 |
| CF / EBITDA | $1,500,000 | $1,500,000 |
| Multiple | 7.0x | 7.0x |
| Valuation | $10,500,000 | $10,500,000 |
| Annual Growth Rate | 1.0% | 7.5% |
Once we move beyond profits and explore other aspects of the financial practices, we can see that the growth of the two firms has been quite different over the past few years. RIA 1 could also have a very high percentage of revenue generated from its top 5 clients leading to higher risk. These are just a couple of examples of growth and risk, but many of the above factors could impact an investment advisory firm's value.
The advantage of using multiples, including revenue, EBITDA, and others, when valuing an RIA is simplicity. One can get a quick "ballpark" valuation of the practice by doing simple math, but when it comes to making important decisions, multiples fall short of assessing the unique aspects of each financial planning firm.
Discounted Cash Flow
Another method often used to value financial advisory firms is the Discounted Cash Flow method, which uses historical performance, discussions with management, and a thorough understanding of the specific business model to project future financial performance over a defined period. One then calculates a terminal value and discounts all resulting cash flows to present value utilizing a discount rate that reflects the perceived level of risk present to that specific company. The final value is the terminal value plus the discounted cash flows.
While this method relies on some assumptions and predictions, it allows a valuation expert to assess the business as a whole. The specifics of a good Discounted Cash Flow valuation can be quite complex and will involve many relevant factors specific to valuing wealth management firms, which is why it's often best to utilize a valuation expert.
