In the fourth part of his look at external investment in law firms, Jeremy Black of Deloitte looks at the various methods to value equity
[1]Cash in hand: law firms are hard to value
One could spend one’s life looking at valuation theory, and many people do, but want I want to do is cover it very briefly, providing you with some theory and some application.
While there are many different valuation techniques, what you are really trying to get at is how much cash you will get from your equity stake. If you knew all the future spare cash that the business would generate for the equity holders, then that would be the value to the equity holders. The only adjustment you would make would be to discount the amounts to take account of the fact that amounts earned in the future are worth less than those earned today. And that’s the discounted cash flow technique.
Of course in the real world you generally don’t know what cash will be generated – therefore for any business it is not as easy as it sounds. However, valuing law firms, where the partners both own the business and work in it, provides further challenges. The problems are:
- You can’t work out how much of the remuneration received by partners relates to the work they do in the business and how much is a return for their ownership;
- All of the profit is paid to partners, so there is in fact no net profit/surplus cash;
- If you took away the carrot of partnership, you would have to pay non-partner fee-earners more.
All of these mean calculating the value of the business from a theoretical perspective is difficult.
However, there is another way to arrive at a valuation and that involves looking at similar businesses, and seeing how much the equity in those is worth. I’ve called these ‘comparables’. If you took a law firm and assumed partners were paid a salary and bonus (and you decided how much this would need to be to keep them motivated), then there are a number of fairly common different bases you could use:
P/E – (used for listed businesses) compares the price of a share to the earnings per share, i.e. what multiple of its earnings is it worth?;
EV/Revenue – what is the enterprise value (the value to all investors – debt and equity) compared with the revenue?; and
EV/EBITDA – what is the enterprise value compared with its earnings (and earnings is taken as the amount in the profit and loss before taking off the cost of interest, tax and depreciation).
So the sorts of numbers you would be looking at are:
- P/E ratio of 10x
- EV/Revenue of 1-2x
- EV/EBITDA of 6x
- In the final part of the series, I look at what private equity firms want from potential investments and the ups and downs of a public listing
Jeremy Black is associate partner in the professional practices group of Deloitte. The first three parts of this series can be found here [2], here [3]and here [4].