Understanding the valuation calculation of a Registered Investment Advisory (RIA) firm.
At some point, most advisors contemplate buying or selling a RIA firm and the obvious first question they have is how to properly value a firm. Assessing the value of an RIA firm has many variables. It is important to start with a simple baseline knowledge also known as “the rule of thumb valuation”. Estimating the value this way allows you to estimate a fairly accurate price range for the advisory firm without getting deep into the weeds. This method cannot substitute a formal valuation. It is just a quick way to get a feel of the potential value.
RIA Valuation Approaches
There are three approaches commonly used to estimate the value of a RIA business. They are the Asset-Based Approach, the Market Approach, and the Income Approach.
In this approach, the assets and liabilities of the business are evaluated for their fair market value. Because most financial advisory firms do not have large tangible asset bases, this approach renders a very low or irrelevant value in relation to the actual market valuation. For instance, the typical financial advisory practice might be valued at over 200% of revenues, yet the total book value of the assets of the firm would be around 5% to 10% of revenues. Because of this, the asset-based approach is not used to value privately held advisory practices.
The market approach uses valuation multiples/ratios from public companies and/or current market transactions involving companies that are similar to the business that is being valued. Certain variables will be taken into account such as size differences, liquidity, retention and capital. These multiples are often used in the financial services sector:
- Earnings before interest, taxes, depreciation and amortization (EBIT or EBITDA)
- Amount of Assets Under Management(aum)
In most conditions, these multiples are easy to determine and are often referred to by financial advisors to value their firm. However, these multiples can be misleading due to the fact that client retention can not be accuratly calculated.
The income approach is the most popular valuation approach of financial advisory firms. It uses the present value of future cash flows to calculate the value. The Income Approach is used in the Capital Asset Pricing Model (CAPM). The capitalization of cash flow analysis is useful because the fundamental principles used in the valuation of privately held businesses.
Example of a RIA Firm Profile:
A fee-only RIA firm that has two principal partners and 2 staff members. Assume the client base is static and the firm transitioning to new ownership is accepted by the base. The firm income statement looks like this:
Gross Revenues $1,000,000 = 100%
Direct Expenses ($200,000) = (20%)
Gross Profit $800,000 = 80%
Operating Expenses ($100,000) = (10%)
EBIT $700,000 = 70%
Capitalization of Cash Flow Analysis
Applying this approach follow the following steps:
STEP 1 — Make necessary adjustments to the Income Statement
Adjustments should be made to past financial statements to simplify the returns. These adjustments include all non-recurring, non-operating and discretionary items during a specific period.
For example, the potential new owner would not have the same expenses as the existing owner. These expenses should be removed.
Examples of adjustments to the income statement include:
- Rental expenses
- Travel & Entertainment expenses
- Non-business related legal expenses
- Support staff expenses
- Automobile expenses
Removing these expenses will give you a more realistic picture of the RIA’s true earnings.
STEP 2 — Calculate Free Cash Flow
The definition of Free cash flow:
Free cash flow (FCF) is a measure of a company’s financial performance, calculated as operating cash flow minus capital expenditures. FCF represents the cash that a company is able to generate after spending the money required to maintain or expand its asset base.
The capital expenditures the RIA firm incurs (investments in computers, software and equipment) must also be subtracted from EBIT to determine free cash flow.
STEP 3 — Determine a Discount Rate
The Discount Rate projects current market value or present value (PV). It is always less than 1, and is dependent on the cost of capital (current compound interest rate) and the time difference between the date of investment and the date returns begin to flow.
The risk premium for the RIA industry typically falls between 5% and 10%. Here are some of the factors that should be considered:
- Investment portfolio
- Variable income
- Managerial functions
- Assets under management (aum)
- Market positioning
- Current economic conditions
- Business cycle position
- Client quality
STEP 4 — Determine the Growth Rate
The growth rate that is expected to be maintained over the next few years. This rate will differ based on the size and age of the existing practice. A practice that is over than 10 years old and fairly stable should not exceed a growth rate in excess of 8%. A growth rate between 3% – 5% is a typical area of expectation. Formal valuation projections will typically use a 5 year time frame.
STEP 5 — Calculate Free Cash Flow for a year
If the firm is over 10 years old and therefore considered established. The Free Cash Flow number should be based on the previous year.
STEP 6 — Calculate the valuation
This will give you a starting estimate of an asking price of somewhere in the area of a $2,000,000.00 ($1,600,000.00 – $2,400,000.00) valuation.
Keep in mind that this method differs from the traditional formal valuation process becase of the nature of the RIA business and therefore does not take into account the many smaller items refinements required in a formal valuation. In an actual transaction scenario, additional factors affecting market value are:
- The client need
- Traditional client contracts
- Physical property
- The traditional fee structure
- Traditional financing
- A traditional balance sheet
While this method may be used to quickly estimate the potential value of an advisory firm, a more formalized process is recommended for your succession planning purposes.
Written by: Edward Romanowsky, President & CEO of Aurora Compliance Solutions