Now let's consider Company B. It has only a 15% profit margin–but gross revenue also is growing 17.5% a year. Therefore, by the end of the first year, the company's revenue has grown to $1,175,000. At a 15% profit margin, its total profit comes to $176,250. The second year, revenue grows another 17.5%, to $1,380,625, and a 15% profit on that comes to $207,094. These trends continue and, at the end of five years, Company's B total profit comes to $1,248,552 on $8,323,682 of total revenue.

So the two companies generate practically the same cash flow (or profit) over five years, but they use two different methods to do so–one based on profit margin and growth and the other on profit margin alone. Both factors have merit, and each should be considered when calculating the value of a business. But how much weight should a buyer give to each? If you don't expect to invest much in the business, then your key valuation factor will be profit margin. On the other hand, if you expect to put a lot of capital into the business to generate additional revenue, then growth potential will be the more important valuation factor. Most agency buyers place the emphasis somewhere in the middle.

One way of looking at the relative importance of growth and profit margin is to consider the two factors from a “wasting asset” perspective. With this valuation approach, the assumption is that nothing is invested in growing an agency. That usually results in a negative growth rate, which is offset by an extremely high profit margin.

Assume an agency with initial revenue of $1 million is going to be permitted to waste away. Since only absolutely essential costs must be maintained, the agency enjoys a 35% profit margin as its book dwindles by 5% a year. At the end of the first year, revenue falls to $950,000, but profits are a strong $332,500. Over the next five years, both figures steadily decline, with annual gross revenue falling to $773,781 by the end of the fifth year. Still, the owner takes out more than $1.5 million in profit over that time span. That illustrates why some retiring agency owners elect to “waste” their agencies rather than sell them outright.

Let's take one more example. Company X has a 20% profit margin and a 5% growth rate, while Company Y has a 15% profit margin but a 20% growth rate. Both start out with $1 million in gross revenue. If we consider only the profit margin in valuation, Company X appears to be the more desirable. But thanks to its superior growth rate, Company Y actually will generate $179,105 more in total profit over five years than will Company X.

So growth is important, but not all agency valuation methods take it into account. For example, the traditional “multiple of commissions” method (e.g., buying an agency for 1.5 times commissions) does not focus on growth (or, for that matter, on profit margin). This crude but widespread valuation method sees no difference between one agency growing 10% annually and another at 20%–as long as at the moment both happen to have the same sales commission revenue.

Valuations based upon multiples of EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization) also consider only profit–not growth–and the definition of profit is dubious. Should an agency growing at 10% be priced at 6.0 times EBITDA while 20% growth gets you 7.0 times EBITDA? It's hard to say, because the formula does not adequately consider the value of growth.

Growth clearly is a key to an agency's value, and yet two common insurance agency valuation methods–multiples of commission and multiples of EBITDA–ignore it! No wonder so many agency owners make bad deals!

Another problem with these two methods is that neither considers the possibility that revenue, profits or growth will turn out to be materially less than projected, adversely affecting cash flow. Such outcomes are caused by risk factors. For insurance agencies, risk factors include the agency's financial stability, volatility of any target markets, concentration of business with too few accounts and companies, below-average retention, the quality of employee contracts, quality of management, E&O status and so forth.

The best solution is to use one of two formulas that consider profit, growth and risk. The capitalization method is the simplest; its formula is: Value = Profit/(Risk-Growth). The second method, discounted future cash flow, is more complicated; however, software is available to help with the calculation. Many similar formulas exist, but they are all derived from these two.

Such detailed agency valuation methods require digging into operations and financials–and therefore are more challenging to use. But buying or selling an agency is an important transaction, so valuations are well-worth doing correctly.