Buyers Math: Revealing The True Logic Behind The Myth of Multiples

Multiples of earnings or revenues are simply a translation of the sales price paid for an agency applied against a low common denominator or metric of an agency at the time of sale. It is appropriate to use multiples as reference points to what the current market value is of an acquisition. However, it is in no way indicative of the way that many of the large acquirers and consolidators formulate their purchase prices.

We recently had a client announce to us that he valued his agency at two times revenue. When asked how he formed his opinion, this highly educated and experienced professional stated that he had heard one of his peers went for that multiple. When asked what his profitability was within his agency, he said that he had no knowledge nor was it important, in his opinion.

That is entirely incorrect.

If an agency yields no earnings or free cash flow, then what is the value?

Essentially, there is no economic value that currently exists within that agency. While there may be some intangible value that exists, it is difficult to even begin to know what type of value proposition this business would create for an acquirer.

To obtain a better understanding of how an agency is valued within a transaction or to know how the actual purchase price is developed, you must go to the two key buyer segments within the industry. The largest buyer segment continues to be the large, publicly-traded brokers. The second largest and quickly growing buyer segment is the banking industry.

It is important to note that neither segment necessarily adheres to the same basis for valuing agencies during a purchase. But one important fact remainsneither one sits within their empires and scratches multiples on the side of an envelope to determine purchase prices.

The following is a summary of the two most widely used methodologies in determining purchase price in agency acquisitionsaccretive analysis and ROE (Return on Equity).

An accretive analysis is one of the most commonly used methods among acquiring public company brokers. Rarely will a public company do anything that will dilute its shareholder value. Shareholder returns are computed based upon earnings per share.

To understand how this analysis is computed, you must first go to the acquiring companys forward earnings estimates. Included in these forward projections are expected earnings per share results. The investment community, including investors and analysts, expect the company to achieve these results.

The next step is to combine, or to merge, the acquired entitys results into the forward projections, which includes an assumption of purchase price paid for the entity. If the combined, merged results either remain neutral or increase the earnings per share, the purchase price is generally viewed to be within an acceptable tolerance range.

Many acquirers have developed models that allow for "what if" scenarios to ensure that the purchase price fits within their own internally determined range for earnings per share. It essentially becomes a "solve" to the right purchase price based upon the buyers determined tolerance.

Many buyers insist on adding at least 50 basis points to the earnings per share, while others have much loftier expectations. It largely depends on how these companies are performing within their organic results (results excluding acquisitions), in addition to what the investment community expectations are in the near term.

A professional financial advisor should be able to help you evaluate reasonable ranges of purchase price based on the buyers earnings profile.

Looking at ROE, many banks operate their acquisition strategies by establishing tolerances on expected rates of return of capital deployed. In general, banks expect a rate of return of between 10 and 15 percent of capital. Essentially, this can be translated into purchase price. This is a much simpler model to work throughby using the reciprocal of the expected rate of return.

For example, if an agency is generating $1 million of "normalized" free cash flow after tax, a bank that desires a 15 percent rate of return could pay $6.67 million in purchase price without diluting its return on equity. A bank that desires a 10 percent rate of return could afford a $10 million purchase price.

Two important points that need to be inserted into either methodology are the intangible value of the agency and supply and demand. While you can employ a mathematical formula to help determine how buyers may value agencies, the critical fact remains that each buying institution has its own individual thresholds, or appetite, for acquisitions.

The individual target agency creates a different value proposition for the acquirer, which can result in marked deviation of the numerical values. For example, banks in many instances will sacrifice their expected rates of return simply to make an entrance into insurance product distribution. A large number of banks take a much longer-term view, recognizing the potential cross-sale synergies that exist in their customer base, and can afford to be more patient with their return.

Brokers that see a unique opportunity where they can capitalize on, or synergize a unique product or service offering, are more likely to lower their earnings per share tolerance near term. However, rarely will they do anything that creates dilution.

As more privately-held agencies are deploying their own acquisition strategies, it is advisable to deploy a hybrid method where both of the outlined approaches can be blended to determine an acceptable value. Much depends on the acquiring agencys size, profitability, access to capital and ability to integrate the target acquisition.

The important fact remains that when it comes to considering the sale of an agency, the assistance of a professional advisor with industry knowledge becomes critical to understanding and determining the purchase price range.

Most professional advisors should guide the agency owner through this process and deliver an analysis of the buyers pricing tolerance before offers are ever made. This is an important part of the process of selling an agency that should really serve as a precursor to discussions with any targeted buyer.

Robert J. Lieblein is managing principal and Steven S. Wevodau is principal of WFG Capital Advisors (www.wfgca.com) headquartered in Harrisburg, Pa. They can be reached at rlieblein@wfgca.com or swevodau@wfgca.com.

Reproduced from National Underwriter Property & Casualty/Risk & Benefits Management Edition, December 12, 2003. Copyright 2003 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.