Coming Up Threes

I had an epiphany the other day. I received a call from an old friend who had an opportunity to purchase an insurance brokerage and I then spent the better part of an afternoon convincing her that the brokerage was overpriced. The owner of the brokerage wanted three times annual commission revenue – and had a line-up of several brokerages prepared to meet that price. Outrageous!! What is going on with the value of brokerages?

We talked about the obvious answer of supply (low) and demand (high). We spoke about a multiple of three making sense for an insurance company that had a roll-over opportunity and could factor in the return on investment (ROI) of the insurance company returns on the new business.

We talked about interest rate risk; about the old Clarkson Gordon valuation model of the mid-’80s, which some banks and insurance companies still use. We discussed ranking investment opportunities by using an internal rate of return analysis.

We talked a lot about the worth of a hypothetical brokerage that exists in a vacuum – a brokerage that never gained or lost a client, and never changed its rates up or down. Such a brokerage, we figured, would be worth two times commissions if the cost of capital is 10% and the EBITDA is 20% (a simple mathematical exercise: if a brokerage with $1,000 commission returns 20%, i.e. $200, you simply have to plug in the formula for the present value of a perpetuity to come up with a value of $2,000 – which is two times).

So why would she, or anyone else, pay three times? It didn’t make any sense to me. And then, I had my epiphany.

The simple concepts that resulted in an industry-accepted rule of thumb of two times [2X] remain sound. But it is the inputs into the 2X that have changed without my noticing. I had fallen into the same kind of logical thought process that results in some knuckle-dragging troglodytes espousing the importance of an underwriting “profit.” (Anyone who doesn’t believe in the time value of money, please line up to give me $1 million; I will happily pay it back in full in 10 years!) I had neglected to appreciate fully the effects of significant changes to the inputs into the equation.

To begin with, nothing is inherently “right” or “wrong,” or even mildly interesting, in a multiple of commissions. What you are purchasing is the present value of future income. Looking at “value” from a multiple of commission perspective is simply a validation of some other valuation methodology.

Assume the $1,000 commission-income brokerage mentioned above. In a proverbial vacuum, with a cost of capital of 10% and a return (profit) of 20%, the present value of future earnings calculation can be validated by the 2X commission rule of thumb.

But now assume a cost of capital of 5%. Exactly the same mathematical exercise validates a purchase at 4X commission. Likewise, if interest rates were to be calculated at 20%, the purchase would appear to be validated at one times commission revenue!

The same calculations can be done with different profit or EBITDA values, yielding similar results. Given that there is plenty of cheap capital chasing a limited number of brokerages for sale, it makes perfect sense that the going price for a well-run, profitable brokerage is around three times commission income.

I am not nave enough to believe that valuation of a brokerage is a simple mathematical exercise based on setting up a balanced teeter-totter effect with EBITDA, cost of capital and the present value of a perpetuity. Obvi-ously there is an art to adjusting the price based on the likelihood of rates staying the same, profit increasing or decreasing, markets, infrastructure, ability to grow, ability to manage more effectively and a thousand other subjective inputs – but three times?

Yes, it seems like a pretty good starting point all of a sudden!