There are a wide variety of methods and approaches that can be used when determining the value of a financial services business. There are three valuation methods that are commonly considered. In many instances, one of these valuation methods may suffice, but depending upon the circumstances, it can be beneficial to use a combination of these valuation methods to achieve a detailed and accurate representation of the firm’s fair market value.
Method 1: Market-Based Valuation
The market-based valuation method utilizes technical analysis and known transaction values to determine the value of a business. This is similar to how real estate agents will assess the value of a home, using comparable homes, to determine a fair price (the market value). The challenge in the financial services industry has been that accessing this transaction data is not readily available from private transactions unless the data is aggregated by a firm who handles the transaction and provides valuation services.
Given that no two practices are exactly the same, adjustments must be made in the assessment to account for the differences between them. A market-based valuation can be particularly beneficial in a number of scenarios, most commonly when working toward setting an offer or asking price within a prospective business deal. It can also be helpful when negotiating buyouts and in some cases can be necessary to demonstrate the value of a company to tax authorities or within legal disputes.
The factors used to determine the market value of a Registered Investment Advisor, IBD advisor, tax practice, or agent/agency practice are numerous, but the most important factors include the total revenue, percentage of recurring revenue, growth rate, age of clients and average account sizes, location, client service model, and profitability. The use of a market-based valuation is at its best when there is accessible and relevant data available for the comparable entities, and there are enough similar businesses to compare it to. When data is limited or not publicly available, it will likely be better to pursue alternate valuation methods, or partner with a firm like SRG that specializes in assessing that particular market.
Key advantages of a market approach to business valuation include:
- By comparing businesses in an “apples to apples,” the valuation result is grounded in reality since the value is determined using current transactions of similar firms, and value comparisons are easy to understand and can be highly useful in terms of providing the user with actionable information.
- There is very little reliance on forecasts of revenue, expenses, and cash flows, or the numerous other assumptions involved in an income based valuation for example. The market approach instead takes actual data from a comparable company to help inform the value of a specific business.
- It is flexible in that adjustments can be made to account for differences in parameters such as size or quality.
- By using actual transaction data of comparable advisors/agents/accountants that have sold, the valuation can also include deal specific considerations, such as expected payment terms.
Key downsides to the market approach include:
- Within some industries or scenarios, relevant comparable companies may be unavailable, or too few to serve as a reliable sample set. Especially when dealing with private companies, it can be difficult to find sufficient market data to inform a valuation.
- Data must also be carefully selected and analyzed to present an accurate comparison.
Learn How SRG Helps Financial Firms Determine Market Value
Method 2: Income-based Valuation
The income approach prioritizes the earning capacity of a company to inform its fair market value. Within this company valuation method, a business’s past, current, and anticipated future cash flows will be analyzed to determine its value and an expected return on the investment moving forward. Various methods to generate income valuations can be implemented, including:
Capitalization of Earnings / Cash Flows Method
This income-oriented approach is used to determine a business valuation based on its future estimated benefits. This estimation is typically calculated based on the earnings or cash flow for the given business. The estimated future benefits are then leveraged in a capitalization rate to determine a businesses rate of return. This method is most appropriate for mature and stable businesses that can reasonably expect future incomes to grow at a constant rate.
Discounted Cash Flow Method
The Discounted Cash Flow (DCF) Method is used to estimate the value of an investment based on its expected cash flows, looking at the operating cash flow, discretionary cash flow, or after-tax cash flow. By using the DCF method to create future projections on how much money the business may generate, it can inform the investment’s current market value. This method is best suited for companies that have a lack of earnings history or have uneven growth in their future benefit streams.
Excess Earnings Method
The excess earnings method is often described as a hybrid method, as it references both the company’s asset values in addition to discounting expected cash flows. This simple approach discounts company earnings by leveraging data from two capitalization rates: a rate attributable to company goodwill (intangible assets) and a rate of return on tangible assets. This method is preferred when assessing the value of financially sound, large businesses with significant amounts of goodwill. The excess earnings method can also be used within an asset-based valuation approach (which we will also discuss later on).
Key advantages of a income approach to business valuation include:
- Income-based valuation methods are widely recognized and helpful in giving a sense of future earning potential. Since the market value of a company is often viewed as the present value of its future cash flow or earnings, this method can be instrumental in demonstrating the true value of a company.
- Even if there is no active market for the given business, a market price can be simulated by using accessible income data.
- An income approach is considered to be generally flexible for assessing the value of a business, regardless of the stage it is in as a company.
Key downsides to the income-based approach include:
- There is inherent risk with projecting future cash flows as it is not an exact science and variables can change the trajectory of a business and their earning potential. This reliance on hypothetical projections has the potential to be inaccurate.
- Income -based approaches assume that the current cost structure of the firm will be retained by a buyer, and for many advisors/accountants/agents, a buyer will only value and acquire the revenue and clients, making the seller’s ability to generate profits less relevant to the exercise.
- The process is highly subjective. Discount rates that are utilized for example have many variables, and determining an appropriate figure is subjective based on the expertise of the valuator. The combination of assumptions, if each is off slightly, can have a compounding effect and render the valuation unreliable.
Method 3: Asset-Based Valuation
Similar companies can also be compared through an asset-based valuation. An asset-based valuation shifts the focus to the net value of assets within a company or the fair market value of the company’s total assets (after deducting its liabilities). Through this exercise, asset valuation can help illustrate the cost of recreating a similar business by highlighting the assets needed for operating a similar company. Along with the aforementioned excess earnings method, the asset accumulation valuation method is commonly used within the framework of asset-based valuation. However, for financial service firms and other similar professional service companies, asset-based valuations are not used due to the fact that they have very few tangible assets and derive their value from goodwill and cash flow.
While there are many different methods of valuation available, these three valuation methods are the most common, and the income and market based methods are the methods used for financial service businesses (and most other professional service companies). Because each company’s situation is unique, the approach to determining the value of the business is not uniform across all companies. In fact, the data presented through a valuation analysis should be assessed with the context of a specific business and its role within the industry in mind. Arriving at an accurate valuation may also require the use of multiple methods to accurately represent the value for a business.
While this can be a daunting undertaking for a business, working with industry professionals to manage the process can help ensure accurate and thorough results. Succession Resource Group provides the most comprehensive valuation services in the financial industry and has decades of expertise in the field, having valued hundreds of businesses in just the last 12 months. If you are buying, selling, or planning the sale of your business, we can help complete your project efficiently and cost-effectively. Please contact us today for an initial consultation and let us help guide you through the valuation process.
This paper intends to critically analyse traditional and contemporary methods of investment valuation. It pays particular attention to the ‘All Risks Yield’ method, commonly known as a term and reversion which is a traditional form of valuation, and the discounted cash flow method which forms the basis of the contemporary method of valuation used in this paper.
The All Risk Yield method combines the Term value and the Reversionary Value together. The Term value is calculated by capitalising the current rental income produced by the current tenant and the Reversionary value is the value of the property back in the Landlord’s possession. Simply put, “an all risks yield may be defined as a method that simply reflects implicitly all future benefits and disadvantages of an investment” (Scarrett, 2008 p.79). Discounted cash flows on the other hand are defined as, “the discounting of all future receipts and expenditures readily allowing for inflation, taxation and frequent changes” (Shapiro et al, 2009 p.173). All of these receipts and expenditures are added up to produce a cash flow sum, that cash flow sum produces a value which a reasonable investor would expect to pay for a particular investment.
Both of these methods will be used to undertake a valuation of a hypothetical property located in the City of Manchester. The results of the valuation can then be compared and contrasted to solidify the three arguments made within the body of this paper. These three arguments are as follows, firstly that although both methods rely on making assumptions, the assumptions made within the Discounted Cash Flow are largely unforeseeable, questioning the accuracy of such assumptions. The second argument deals with the challenges set by the All Risks Yield and the third argument sets out that both methods have their strengths and weaknesses. The valuer should give proper consideration as to his client’s instructions in order to select the most appropriate method for the type of valuation he has been instructed to carry out.
Now that the basis of this paper has been set out the valuation of 1 Imaginary Street can be set out below. 1 Imaginary Street is a multi-let office block in the City of Manchester. It was purchased by an Investor for £600,000 and it forms part of his retirement portfolio. He wishes to hold the investment for approximately 25 years. It is fully occupied and the lease terms for the two tenants are as follows:
Let on a 3-year full repairing and insuring lease, paying a rent of £20,000 per annum. The current market stands at £22,000 per annum.
They are an established tenant and offer a good covenant strength.
Let on a five-year full repairing and insuring lease at a passing rent of £25,000 per annum, they have a rent review at year 3 on upwards only terms. The current market rent stands at £28,000 per annum.
Similarly, to Tenant A they are established and offer a similar covenant strength.
The All Risk Yield is 7% for the term and have been slightly adjusted on the reversions to reflect the added risk of the properties becoming vacant at the end of the tenancies. They have been adjusted as follows, 7.5% for Tenant A as they are held on a shorter lease than Tenant B and 7.25% for tenant B.
Taking these tenancies into account the Term and Reversion valuation has been set out below:
Moving onto the Discounted Cash flow, there are two principle methods in use, both of which have been calculated. These two methods are the net present value method and the internal rate of return method (Shapiro et al, 2009 p.174). Typically, the net present value (NPV) method is used for analysing the specific cash flow of the investment with the initial purchase cost. If there is a positive NPV then an investment is worthwhile, if there is a negative NPV then the investor will lose money and then investment is not a good one to pursue. The internal rate of return (IRR) method is used to calculate at a given discount rate what the minimum return of investment the investor requires to break even. Put simply the IRR is a tool used to compare the risks of one investment with another. The discounted cash flow can be found below:
Now the valuations have been carried out we can now critically analyse the use of both methods. The first point this paper wants to argue is that both methods are relying on assumptions in order for capital values to be calculated. Shapiro et al rightly notes that, explicit assumptions must be made for discounted cash flows and implicit assumptions for the all risks yield approach (Shapiro et al, 2009 p.174). Explicit meaning assumptions made clearly with little doubt and implicit being more suggestive and reasonable than verbatim. Implicit assumptions for example may include that the property is being sold at an arm’s length transaction or that all legal documentation for the conveyancing is in place and there is nothing to hinder the property’s value as a result. Implicit assumptions form part of the all risks yield, for example if there was a problem with the property legally or physically then there would be more risk and the all risks yield would be adjusted to reflect this. In the term and reversion of 1 Imaginary Street it has been implicitly assumed that there are no such hindering physical or legal defects which could hurt the value of the property.
On the other hand, the discounted cash flow of 1 Imaginary Street has explicitly assumed that the property will be occupied for the entire holding period of 25 years and that the growth rate will average out at 3%. This however is problematic. As Brown et al note argue, “the test of valuation is as much about the forecasting ability of the valuer as it is about their ability to interpret information (Brown et al, 1998 p.2).” What Brown et al are implying is that the valuer can only reasonably value a property if they have all of the facts. Explicit assumptions cannot be reasonably made for a long-term discounted cash flow as future events such as a change in market conditions are highly likely to occur, effecting growth rates and occupancy rates just to name a couple of examples. The RICS have also stated that, “forecasts of property market movements are incredibly difficult to make (RICS, 1997 p.23).” The case of Singer and Freidlander Ltd v John D Wood and Co [1977 2 EGLR] arose because of this assumption’s dilemma. In this case a valuer was found negligent over his analysis of the information at his disposal and the assumptions made. The judge ruled that, “any valuation falling outside of a bracket (margin of error) brings into the question the competence of the valuer and the sort of care he gave to the task of valuation (RICS ISURV N.D.).” Both methods of valuation as demonstrated with 1 Imaginary Street rely on the use of explicit and implicit assumptions. A valuer cannot be held negligent if market conditions change, provided that the information and assumptions at the time of the valuation were accurate. However, there is a strong case to be made that explicit assumptions are riskier than implicit assumptions and valuers should exercise additional caution when undertaking discounted cash flows.
The second argument this paper makes is that there are challenges posed with the all risks yield. One issue with the all risks yield approach is that because it is implicit in nature, it is perceived to not take growth into account. As argued by Scarrett and Osborn who warn that the consequences of this is that it makes it “difficult to know the effect of any yield adjustment,” (Scarrett and Osborne, 2008 p.101). One must disagree with this argument however, whilst it is agreed that implicit approaches are most restrictive the valuer should still take into account the prospective of growth when calculating the all risks yield. A property with little prospect of growth will have a higher all risks yield to reflect the lower capital value, and vice versa for a good prospect of growth.
Discounted cash flows are more beneficial for growth focused investors as the growth rate can be accounted for with the cash flow model. As seen within the cash flow for 1 Imaginary Street. The downside of this however is that the growth rate is likely to be wrong in the long term as Medium Term Treasury bonds are used as the benchmark for calculation. Bond markets are not stable and although are less volatile than equities, they still change over time. At best the growth rate is arguably a ‘guestimate’ made on mathematical models which may seem rational but do not stand the test of time in the real world as markets change over time.
The RICS make a strong point that, “one problem with the all-risks yield is the difficulty of assessing transaction evidence….and making a suitable adjustment. Even a minor difference such as a rent review for one property being closer than that for another may make comparison difficult” (RICS, 1997 p.12). This is an important point raised by the RICS as in the case of 1 Imaginary Street. An all risks yield of 8% will lower the capital value when compared to an all risks yield of 7%. Yet no valuer processes information in the same way and some may use a yield of 8% and still justify the valuation without acting negligently.
Just like in the term and reversion and the discounted cash flow the valuations are different. There are two reasons for this, firstly the term and reversion defers the reversionary value for 3 years which impacts heavily on value and secondly the discounted cash flow uses a discount rate of 7% compared with the all risks yield of 7% for the term and 7.25/7.5% for the reversion. Both of these values differ yet because they can be reasonably justified so neither one is wrong. This in turn identifies a problem, that two different methods can produce two different valuations. Scarrett agrees, he says “it is unlikely that two valuations would produce precisely the same value, even if they do so the components would vary (Scarrett, 2015 p.231).”
It’s also equally important for the valuer to focus on the type of client he is working for and the reason why he is investing in property. 1 Imaginary Street was purchased for £600,000 for the client’s retirement fund. One has to ask the question, is growth all that important to this particular client? Probably not. The client wants a property that can provide steady and reliable cash flow over the duration of his retirement. Arguably as long as rents grow in line with inflation the investor will never miss out and if he retains the property for the rest of his life, he’ll never see the benefit of any capital value growth anyway. Therefore, this investor will be more concerned with the covenant strength of the tenants and whether the rental income can cover the cost of his retirement. Nick French has studied this exact issue and concludes that, “if the client requires an open market valuation then the existing all risks yield method should be used, if the client wants an indication of “worth” to them, then perhaps a Discounted Cash Flow approach is more appropriate” (French, 1996 p.49).
The above point ties into the third argument this paper wishes to make which is, both methods have their strengths and weaknesses and that’s not a bad thing. The reason why it’s acceptable for the methods to have pros and cons is because, “the valuation basis must be appropriate for the purpose of the valuation (RICS Global Standards, 2020, p.35).” This is precisely what Nick French is arguing. The RICS have come to the conclusion that traditional methods are valuable and have their use but sometimes a discounted cash flow is more appropriate and valuers shouldn’t shy away from undertaking them (Shapiro et al, 2009 p.172). The question comes down to, what is the purpose of the valuation? This is where the valuer must use his experience and judgement. If the client is a complex institutional investor who wants a breakdown of cash flow, taxes and costs to calculate the worth or to compare the risk of one property with another through the internal rate of return then a discounted cash flow is appropriate. If it’s a simple question of value and that’s all the client needs, then a term and reversion is more appropriate.
One would argue in the case of 1 Imaginary Street the all risks yield method is more appropriate for the client’s circumstances, however it has been an interesting exercise to see how the discounted cash flow produces a different valuation and how that valuation of “worth” may be useful to a different client with different circumstances.
To conclude then, we need to remember as property professionals that, “all valuations are estimates and carry with them a degree of uncertainty (RICS, 1997 p.25).” We shouldn’t use assumptions that we cannot reasonably make or use market data that is incomplete or that cannot be understood. Valuers shouldn’t use inappropriate methods which fail to match the expectations of the client and their instructions.
This paper has intended to contribute to such a fascinating academic debate where literature is lacking. There has been very little attention paid by the academic community to this subject and one would hope that further future research is carried out.