Rs.1000 Crore Versus Rs.500 Crore
Let me begin this post with an interesting question that I asked a few distributors.
“Imagine there are two firms in the distribution space… One (Firm A) with Rs.1000 Crore of Assets Under Management (AUM) and the second (Firm B) with Rs.500 Crore of AUM. Which one of the two is more valuable or will get a higher valuation?”
After thinking for some time, most said – the one with Rs.1000 Crore of AUM…A couple of people gave a slightly different answer…Before I tell you what their answer was, let me ask you the second question I asked them.
“There are two other firms as well. Both these firms (Firm C and Firm D) have Rs.1000 Crore of AUM each. Which one is more valuable than the other or do both firms have the same value?”
This time there was some silence…Some thought for a bit and said, “It depends on the revenue of the firm.” A few said, “Depends on the cash flow.”
Now that you know both the questions and some responses, which firm (of the first question) do you think has more value. Which one will you invest in?
Most people assumed that the one with the higher AUM had higher revenue…But the correct answers to both these questions are – It Depends.
You read it right…It Depends on many factors… In today’s post, we will discuss some of these factors and then look at the three key drivers of economic value of any firm.
Let me provide a few more details to question 1 – Firm A has Rs. 800 Crore in Liquid Funds and Rs.200 Crore in Equity. Firm B has all Rs.500 Crore in Equity. Did your answer change now?
Asset Mix of the AUM is thus a critical factor…
The next is Client Mix of this AUM…What if I told you that the Rs.1000 Crore was spread across 10 clients whereas the Rs.500 Crore was spread across 100 clients…Would this change anything for you?
Obviously, it would as the Rs.500 Crore is far well diversified in terms of clients and thus well diversified in terms of Risk (one of the key drivers of economic value).
The third factor is revenue.
What is the revenue of each firm? What is the consistency (stickiness) of this revenue?
The fourth factor is growth.
What is the growth of assets, revenue, and clients in this firm? Some firms grow as the market grows and thus, they grow in revenue as well. But many such firms do not grow in terms of number of clients.
Another important factor is the type of relationship you have with the client. Do you have an account where you have sold some investments, or do you have a real solid relationship where the client trusts you with her/his financial life and 100% of her/his assets?
When you don’t have 100% of client assets, this means there are some other firms competing for business here…Not having 100% or majority of the assets increases risk for the buyer (makes the firm less attractive than it could have been) and therefore reduces the value of your firm. A variation of this is the type of clients that you have. Are your clients retail, mass affluent, high net worth (HNIs), UHNIs, or Family Offices?
Then there are factors such as client demographics, referral ability of these clients, professional alliances, client acquisition engine, value proposition, service model, team, team skill required to deliver this value proposition, cost, business model, investments done in the firm (in terms of technology, processes, client experience) and hundreds of other things.
Let’s look at client demographics and what I mean by this.
What’s the average age of your clients?
Are they in the accumulation or decumulation stage?
What are their financial requirements over the next 3-5 years?
Are they a Corporate Executives or a Business Owners or Professionals? What do they do? Are you known to serve a particular niche?
Are you in touch with the spouse of the client? Have you involved the spouse in the process?
Are you in touch with the next generation? Have you already built a relationship with the children and grandchildren of your clients?
If you are not in touch with the spouse or the children, the risk to the buyer again is higher.
I can unpack many of these factors, but I would then end up writing a mini book on valuations. At this point, it makes sense to introduce the three drivers of economic value of any firm. They are Growth, Profit and Risk.
In short, what is the growth rate of the firm…how profitable the firm is…and what are the risks to this profitability and growth?
To simplify in a language you appreciate, the capacity of your firm to generate cash flows (profit), expected growth of these cash flows and the uncertainty associated with these cash flows (risk).
Many in our industry want to know the multiple that applies to them…Every multiple, whether it is of revenues, profits, or EBITDA is ultimately a function of these same three drivers – growth, cash flow generation potential (profits) and risk…Firms with higher growth rates, greater profits and lesser risk should get far more value than firms that have lower growth, less profit potential and higher risk.
One of the things to understand is that while there are different valuation models there are only two valuation approaches: intrinsic and relative. The three drivers of economic value that I shared above are based on the intrinsic valuation approach. The intrinsic value of an asset is a function of the cash flows you expect that asset to generate over its lifetime and the risks to the cash flows. In our industry, the risks to these cash flows can come from clients walking out with their assets, market risk, reduction in pricing, regulatory changes that pose a risk to current business models, competition and so on.
While the right approach should be that of intrinsic valuation, most assets are valued on a relative basis. In relative valuation, the assets are valued based on looking at how the market is pricing similar assets. And of course, it seems much easier for most people…When buying a house, we determine what to pay for a house based on what other houses in the same apartment complex or neighbourhood have sold for. In the case of stocks, we compare the price of a stock with its peers…and so many look at this easy model.
I hear these naïve statements quite often – Prudent is priced at X so I should at least get X/2…This AMC was sold for a certain percentage of AUM so I must at least get that…My firm is special so I must at least get market multiples…But sophisticated buyers will value your firm based on these three drivers of economic value – Growth, Profit and Risk…Therefore it’s important for you to understand the factors that drive these and what you need to do today to command a higher valuation.