The Basis of a Valuation
Development in this industry revolves around recruiting, retention and training rather than engineering.
By Scott Wright, Director of Mergers and Acquisitions
Valuing residential real estate brokerage firms certainly has its intricacies given the unique characteristics that set this industry apart from others.
For example, in most industries, businesses have an established infrastructure to support the development, production and sale of a tangible product. Residential brokerage firms don’t quite fit this mold. Brokerages don’t sell shiny new products and don’t need big fancy buildings to be successful. Development in this industry revolves around recruiting, retention and training rather than engineering, and the only physical asset that matters at a brokerage firm is a sales professional who can come and go as he or she pleases.
Market Cycles and LTM
Many industries must also naturally deal with cyclicality, but the residential real estate industry lives and dies by market cycles. Real estate is a highly seasonal industry that is at the mercy of economic forces over which it has little control.
Given these unique characteristics, the real estate industry certainly has its fair share of risks. For this reason, the basis of a valuation is always the Last Twelve Months (LTM) of operating results. In our 30 years of performing valuations and serving as the broker in the sale of hundreds of brokerages, there hasn’t been a single instance where we’ve used a period beyond LTM to establish value.
Whether it’s a large national franchise or a small regional brokerage, all buyers we’ve engaged with solely use LTM in their models, as well. Of course, we consider historical financial and operational performance for other factors, but the baseline for determining value is always LTM.
Is LTM Limiting?
Some say this LTM basis is unique and limiting when valuing a business, but is it really all that abstract? Let’s look at the most common form of buying and selling ownership of companies—the stock markets. When a fund manager looks at stocks to add to or remove from his portfolio, one of the key metrics he looks at is the Price-to-Earnings ratio (P/E ratio). This ratio is a measure of value that simply divides a company’s current share price by its earnings. And how are earnings for companies that trade in the stock markets measured? They are measured over the last 12 months!
When you go to Yahoo Finance or Bloomberg to look up a stock quote, the P/E that pops up on the screen is called a Trailing P/E Ratio, which uses LTM earnings in its calculation. Individual investors and fund managers typically have a “what have you done for me lately?” attitude when analyzing a stock, and it’s no different in the real estate industry.
When buyers are evaluating a residential real estate brokerage firm, they want to know what kind of cash this broker is pumping out. This cash flow is always based on “what the brokerage has done lately”—the last 12 months of net operating cash flow.