Valuing your Professional Service Firm

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There are several applications in which the valuation of your business can deliver insight for guiding critical strategic decisions. For example, below are some common scenarios in which a valuation of your professional service firm may be helpful:

How to value a professional service firm

  • Creating an exit strategy plan
  • Executing buy/sell agreements
  • Managing shareholder or partnership disputes
  • Working through a merger/acquisition

These scenarios can come up suddenly or be planned several years in advance. Either way, it is critical to understand what value means for your business. The value of a company is generally determined by using one of the following three approaches:

  1. Income approach
    The income approach either focuses on the business's current or potential revenue and expenses. The value(s) are capitalized or discounted back to the date of valuation, respectively. This method is more complicated than the asset approach (explained below) because it uses current or potential earnings, cash flows, and an estimated return rate. The driving force of value under this method is the benefits of future ownership. The income approach generally requires the highest level of professional judgment to determine a value.
  1. Asset approach
    The asset approach is used by determining the fair market value of the assets and liabilities inside a business. This method is typically used when a company’s value relies heavily on the value of its tangible assets. Using this value puts minimal emphasis on the value of services or products. In some instances, this method is the most probable and unbiased compared to the other two. However, since this method uses appraised or actual values at a given date, it does not consider the earnings potential of the subject business.
  1. Market approach
    The market approach uses data from published sales of similar companies to determine a value. Each company is unique, and therefore professional analysis and recommendation is advised. This method relies on the economic trends, industry conditions, and intangible value of a business associated with customer connections and team experience.

Professional service firms receive their value from the services they provide, typically relying less on tangible assets. Intangible factors such as customer relationships, staff expertise, and reputation play larger roles in the value of a professional service firm compared to other industries.

Generally, all methods will be reviewed for applicability when determining a value. Due to the factors listed above, business valuation experts will often use the income approach to value businesses in this field.

Professional Services Industry

Understanding business valuation methods serve as a baseline for application within the context of a specific industry. The professional services industry can be defined as organizations or professions that provide customized, knowledge-based services to clients. This list can include architects, engineers, lawyers, financial professionals, marketing consultants, among others. Companies in this industry vary significantly due to the services each business provides.

According to the IBISWorld May 2021 Report for Professional, Scientific, and Technical Services in the United States, over the next five years to 2026, the professional services sector will bounce back quickly from the COVID-19 pandemic. The quick recovery can be attributed to the pent-up demand for services which were stymied due to the economic downturn. Sector revenue is expected to increase at an annualized rate of 2.3% to $2.7 trillion over the next five years to 2026. The report goes on to discuss technological advances and the impact they will have on the industry. It also discusses wages and how they account for 41.6% of business expenditures.

Calculating the Value

Understanding the present and projected industry trends plays a significant role in determining an accurate valuation amount. Business valuation experts will look at the firm's historical data and compare it to industry benchmarks and key performance indicators (KPIs). Several resources are used to make these comparisons, but the main one is RMA Statement Studies. They consolidate financial information based on audited financial statements and filed tax returns, which are broken down by NAICS code, annual revenue, and region. Using these numbers, the business valuation expert can compare the company against its competition.

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Although historical data is important, projected growth impacts overall value when using the income approach. Valuation experts will facilitate conversations with management regarding the plans for future growth and compare it to the projected trends discussed above. There is an inherent risk associated with using future earnings potential, given that these results may or may not materialize. This risk will be factored into the overall calculation.

After the balance sheet and income statement ratios have been analyzed and compared to industry standards, the next step is to normalize net income and cash flows. Normalizing is another step in the process that allows companies to be compared on equal footing. Non-cash items are added back, and company/shareholder specific items, which might not apply to a new owner, are adjusted out. The normalized net cash flows are then applied to the chosen valuation method and used in calculating overall value.

One commonly used method to determine if a professional services business meets expectations is comparing it to current industry benchmarks and KPIs. The professional services industry encompasses several different types of companies and KPIs can vary greatly. There are various KPIs that any firm in this industry should monitor, but it is equally important to look at specific indicators which align with your firm's overarching goals.

Professional service firm benchmarking graphic

If applicable, it is essential for business owners and managers to know how each is calculated and how their business continually compares to industry standards. Business valuation professionals have access to research databases that collect each sector's information within an industry. Common data used are industry benchmarks, multiples for sale, and previous sales reported to the database. The information provided for each sector is used in a business valuation to determine if a company meets the industry's expectations. Each piece of information offers a critical contribution to accurately valuing a professional services firm.

QUESTIONS ABOUT WHAT YOUR PROFESSIONAL SERVICE COMPANY IS WORTH?

If you are interested in learning what creates value in a business or want to know more about the steps to complete a business valuation, please contact our team today! Our team of Certified Valuation Analysts are experienced in practicing all the above valuation approaches to perform credible business valuations for a wide variety of clients.

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