The #bankingroyalcommission report has some major recommendations, which will have impacts across a wide cross section of the financial services industry. In particular there is likely to be a major impact on the viability and bottom line of some mortgage broking, life insurance broking and financial advice business.
Which begs the question - to what extent do one-off industry changes impact the value of the business?
The answer to this comes from looking at the P's and Q's of valuation - the price (or EBITDA multiple) and quantity (or ongoing adjusted EBITDA). So there are two key changes that will reduce the value of a business:
Reduction in ongoing adjusted EBITDA from reduced revenue.
Reduction in the EBITDA multiple from increased risk.
The first change is fairly obvious - if EBITDA is reduced on an ongoing basis then the business value will reduce proportionately. I would expect that many of the smaller broking and advice firms are likely to experience this as their business model changes.
The second change is not so clear - I am not convinced the overall risk profile of the sector will change. The demand for product services is likely to continue, although there may be some one-off adjustments. It is not clear if profit margins for businesses that continue in the sector will significantly reduce or change, nor will the resulting uncertainty in cash flow change.
Therefore we can expect little change to EBITDA multiples - for the time being.
An indicator of this is the upwards trend of bank share prices immediately prior to the release of the report. Only time will tell if the Enterprise Value:EBITDA multiple will change, and it will be a feature of our future blog posts.
One would expect that a change in the business model for financial services will change the risk profile of businesses in that sector. However it may be that the overall result of the outcomes of the #bankingroyalcommission is to reduce the ongoing EBITDA of those businesses, rather than increase the risk profile to future cash flows.
An over-riding question for the financial services sector, as a result of the #bankingroyalcommission recommendations, is "will the changes result in permanent changes to the industry"?
If the changes result in 1 or 2 years of lower EBITDA results, then this can be considered as a temporary change, and that valuations in the mid-long term will return to current levels.
A business can experience one-off changes such as a relocation, acquisition of another business, one-off legal case or temporary changes to production capacity. The financial results for the periods in which these changes occur can be disregarded, and ongoing EBITDA results based on more representative periods of business.
But where there is a long term or structural change in an industry, we must look at the impact this has on future cash flow, and hence the impacts on valuation.
Examples where permanent changes has occurred include:
Uptake of mobile phone usage on land-line telephony.
Impact of ride sharing services on taxi industry.
Impact of supermarket industry on home-delivered services such as milk and bread.
Changes in local rail stations impacting localised retail outlets.
One-off changes do impact the valuations of business, and it is likely that the valuations of many small financial services businesses will suffer. At the same time, there will be opportunities that result from any structural change, where some financial services providers may even gain market share.
Only time will tell. But at least for a while, there is a cloud of uncertainty - which you can definitely take to the bank.