Valuing law firms is complicated, but when external investments or capital market listings are allowed, valuation will become essential. Madhav Srinivasan, CFO at Hunton Andrews Kurth LLP, shares his insights into how to look at law firms’ value and measures up the AmLaw 100 to the S&P 500 for comparison.
There are many persuasive reasons to value law firms. While knowing the numerical value is interesting, understanding similarities between shareholders and equity partners; examining equity partner compensation, systematic market risk, taxes and future cash flows are equally valid motives.
Further, value can function as the financial end-result of a firm’s strategic activities and analyzing value drivers can help enhance enterprise value. If and when external investments or capital market listings are allowed, valuation will become essential.
The valuation approach featured in this Insight was to adapt the well-known two stage dividend discount model used commonly to value public companies with steady cash flows. This detailed methodology calculates annual cash flows for the first five years in the first stage and a terminal value based on sustainable long-term growth in the second stage. The ensuing cash flows are appropriately discounted to the present using a cost of capital to ascertain value. This article focuses on two interesting insights.
Comparison to the S&P 500
The value of all the 100 law firms in the 2019 AmLaw 100 was calculated as $247.15 billion (as of May 2019), which was 23.4 times cash flow of $10.6 billion, 21.2 times net income of $11.7 billion, 12.7 times pure pre-tax profits of $19.5 billion, 6.27 times AmLaw operating income of $39.4 billion and 2.50 times revenue of $98.7 billion.
It is interesting to compare the AmLaw 100 market capitalization to similar U.S. publicly traded companies. The top 500 such companies are in the famed S&P 500 index. If placed within the S&P 500, the AmLaw 100 would rank in the top 4% as 17th of 500 companies. Specifically, it nestles between number 16 Walt Disney at $247.26 billion and number 17 Home Depot at $243.70 billion (both companies valued as of August 2019).
Looking at 10 comparable companies lead to even more fascinating results (see figure 1). As to be expected, the median market capitalization is $245.48 billion—very close to the AmLaw 100. But the closeness observed in the other financial parameters is remarkable. The median revenue of $120 billion, net income of $13.9 billion, net income margin of 11.1%, enterprise value to revenue ratio of 2.63, price to earnings ratio of 15.9 are all quite similar to corresponding figures for the AmLaw 100.
The valuation methodology was solidly validated by closeness of derived figures for the AmLaw 100 and observed figures for its two closest operational peer sets: publicly traded U.S. consulting firms and publicly traded UK and Australian law firms. This exercise provides further corroboration. AmLaw 100 is compared to market capitalization peers: renowned companies in the banking, retail, oil & gas, medical, telecommunication and consumer sectors, with surprisingly similar capital market ratios.
What Drives Value?
What drives numeric results of law firm valuation? There are two underlying factors, the first being magnitude of cash flows while the second is annual percentage increase in future estimated cash flows. Value is directly influenced both by magnitude and percentage levels.
Specifically, numerical value is directly proportional to cash flow in the first year and to annual growth rate of future cash flows. To illustrate, value of the hundred firms in the AmLaw 100 is plotted against first year cash flow (see figure 2).
The scatter points slope upwards, demonstrating value increases as cash flow increases, thus the impact of magnitude. For example, a law firm with $400 million cash flow will be valued higher than with $75 million of cash flow, all else being equal.
However, we see one set of points has a much sharper slope than the other set of points. This separation shows impact of growth rate in future cash flows. Firms with higher growth are accorded a higher valuation than firms with lower growth—for same level of initial cash flow.
We see 46 higher-growth firms in the AmLaw 100 have a growth rate higher than the average of 5.94% (from calendar 2014 to calendar 2018) and 54 lower-growth firms have a lower growth rate. The 46 higher-growth firms are on the sharper line with higher slope; and the 54 lower-growth firms are on the shallower line with lower slope.
While average revenue and cash flow for both sets are similar, average value is quite different (see figure 3). The divergence in cash flow growth percentage explains this variance: higher-growth firms have an average growth rate of 9.7% in the first five years compared to 2.7% average for lower-growth firms.
This large differential translates to higher relative valuation for the same level of initial cash flow. The average value to first year cash flow ratio for higher-growth firms is 30.6 compared to 15.8 for lower-growth firms. For example, two law firms with $100 million of cash flow in the first year, the higher-growth firm would be valued at $3.06 billion compared to $1.58 billion for the lower-growth firm, all else being equal.
Valuation of law firms opens up areas for analysis and comparison which are not available when only considering operating parameters like revenue and profits. Law firm values can be compared to publicly traded companies, as in the S&P 500 index, leading to interesting insights.
Magnitude and growth in cash flows are the core building blocks of valuing public companies; and these are also the fundamental drivers of law firm valuation.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.