There are multiple ways to value an investment advisory practice; unfortunately, it has become more of an art than a science due to the fragmented nature of the industry and the lack of similarities among firms.

Additionally, investment and financial planning professionals often have an inflated perception of value.

To help provide a framework for thinking though valuation and what drives value, consider the following methods:

Asset based approach – net asset value is estimated by restating the value of assets and liabilities from historical cost to fair market value. Because most investment and financial advisory practices do not have much in the way of tangible assets, this method is typically not used.

Market approach – utilizes valuation ratios derived from market transactions involving companies that are similar to the subject business. Due to the dissimilar nature of investment advisory firms, using the market approach or “rules of thumb” ratios can lead to inaccurate valuations.

Income approach – expected future returns from an investment are discounted to present value at an appropriate rate of return for the investment.

Also known as the Capital Asset Pricing Model (CAPM), Value is equal to Cash Flow divided by a Capitalization rate which is derived by subtracting a growth rate from a discount rate.

The discount rate, or required rate of return, should reflect the degree of risk associated with the future returns of the subject practice as well as the returns available from alternative investments. This discount rate then derived from risk premiums including the risk free rate, equity risk premium, small stock risk premium, and the subject practice risk premium. Generally the total of these risk premiums range from 20% - 30%. Once the discount rate is established we subtract out the sustainable long-term growth rate which is usually targeted at 5%.

To simplify: V = CF/ (risk – growth)

The very nature of investment advisory and financial planning firms indicates that the income approach is the most applicable due to the lack of tangible assets and dissimilarity across firms to compare transactions.

Therefore, when thinking through how to value a firm, there are three key areas that drive value.

Those key drivers of value are the things in your business that:

1. Increase cash flow, such as efficiencies, technology and scale;
2. Decrease risk, such as a strong compliance culture, no one client or set of clients represents large % of revenues, stability, infrastructure and a strong employee “bench”
3. Increase growth, such as a systematized marketing capability, streamlined operations that can scale easily, broad service offering and a location in an affluent growing community.