By Jerry Butler & Martin Luc Derome
There are a few pieces of the Queenston Proprietary Process that need to be defined:
(a.) Balance Sheet Adjustments: This industry’s assets are made up of 90%+ of intangibles most of which is embedded in the value but not on the Balance Sheet. All valuations and transitions are done, even on a Share Sale, by removing cash, accounts receivable, real estate, debt and any payables. This will leave the hard assets of furniture and equipment which is a small fraction of the value and deemed not material.
(b.) Comparable Company Multiples Approach: This is less of a nominal valuation and more of a selling price estimate. A comparable company multiple is the process of comparing the company being valued with recent transactions of similar companies. Queenston has the most experience and the greatest access to transition values in the country. We use a range of values based on recurring revenues and a percentage of assets to arrive at an average between the two.
(c.) Discounted Cash Flow Method of Valuation: Present value of future cash flow from operations. Queenston uses EBITDA going forward and applies a WACC rate to arrive at a valuation.
(d.) EBITDA: Common valuation acronym of Earnings Before Income Taxes Depreciation and Amortization.
(e.) En Bloc – refers to the value of 100% of the company.
(f.) Income Statement Adjustments: Adjustments are made to normalize the Financial Statements. This is done in an attempt to arrive at the Owner’s Discretionary Earnings. This allows Queenston to compare different businesses and business models in the same industry (financial product distribution industry) to each other.
(g.) Industry Averages: The averages are taken from a Study that Queenston purchases every year of a comprehensive survey of the industry in the US. Though the operations in Canada are different they are not so different that the numbers are not relevant. We use the industry averages to compare to the client company to see if there are any glaring differences. This comparison helps us when doing the Queenston Appraisal Analysis Table.
(h.) Manager Market Income: This is an estimate of what it would cost if the advisor did not own the book and did not have to pay the expenses. Similar to an advisor at a bank owned IIROC firm. We use 25 – 35% of revenue.
(i.) Micro Caps: Most businesses especially with one owner operator in the financial product distribution industry would be classified as being a micro cap size. Mid market size is generally sales of $5,000,000+. This creates several material differences in valuation theory from the standard methods used.
(j.) Owner’s Discretionary Earnings: This method has become very popular in the US especially when valuing small businesses and professional services. It is relevant as it is a cash flow model that can be applied when considering acquisition debt and an income to the buyer. It is defined as the earnings before:
k.) Income Taxes: The term “income tax” refers to a type of tax government impose on income businesses and individuals within their jurisdiction generate. By law, taxpayers must file an income tax return annually to determine their tax obligations.
l.) Non-operating income and expenses: Non-operating income and expenses are most likely to be one-time events, such as loss due to asset impairment.
m.) Non-recurring income and expenses: A nonrecurring expense is a cost the company incurs irregularly.
n.) Depreciation and amortization: Amortization and depreciation are non-cash expenses on a company’s income statement. Depreciation represents the cost of capital assets on the balance sheet being used over time, and amortization is the similar cost of using intangible assets like goodwill over time.
o.) Interest expense or income: Interest expense is the cost of borrowing money, while interest income is the money you earn from investing. Interest expense is typically tax-deductible, while interest income is taxable.
p.) Owner’s total compensation for those services that could be provided by a sole owner/manager.: Owner’s Total Compensation refers to the payments made to owners of businesses for providing services which could be provided by third parties. Owner’s compensation is one of the areas where adjustments in the comprehensive income statement are common because most often, owners’ compensations do not reflect prevailing rates on the market.
(q.) Professional Service Practices: These types of businesses are characterized by types of assets, dependence on the Professional, licenses, limited life of the practice and different value drivers than a “standard” business.
(r.) Queenston’s Appraisal Analysis Table: This part of the process is designed to give an appropriate multiple to apply to the Owner’s Discretionary Earnings. This analysis is an integral part of Queenston’s proprietary process and draws on our experience from the valuations and transitions we have done. It is adapted from the West and Jones, “Handbook of Business Valuations” (John Wiley and Sons 1992) to be specifically applied to the financial product distribution industry.
(s.) Recurring Revenue: For the purpose of the valuation of a financial product distribution business this refers to trailers, renewals and fees.
(t.) Repeatable Revenue: Certain financial products/strategies generate on-going revenue by the nature of that type of business. Examples include term life insurance; GICs; PAC plans or consistent large RRSP deposits.
(u.) Special Interest Purchaser: Purchaser who expect to enjoy post-acquisition net economic value-added by combining the acquired business with their own. Consolidation of two businesses in the same industry can result in economies of scale, synergy and cross selling. 90%+ of transitions (not including inter-generational) involve two existing businesses. A Special Interest Purchaser will usually pay more than a new entrant.
(v.) Weighted Average Cost of Capital (WACC): When developing a discount rate to apply to an economic income flow available to invested capital (equity plus long term debt), the present value discount rate is a weighted average of the costs of debt and equity based on a relative proportion. Most transitions are done with 0 – 25% equity and 75 – 100% debt. To be conservative Queenston usually does the weighting 50:50 with an Equity cost of 20 – 30% depending on transition risk and a Debt cost of 5 – 10% depending on available credit. This would give a range of WACC of 12.5 – 20%. For our purpose we ignore income tax effects.