The business valuation practice area is maturing, and rapid growth is no longer the norm for the profession’s established firms. Although demand for valuation services is robust, it is harder for firms entering the field to earn superior returns unless they have a competitive advantage such as some existing expertise like industry or technical experience or they acquire valuation talent with a book of business. Flatter industry-wide growth is not only the result of generally weak economic conditions but also the evolution of the profession. Without a major innovation or external “shock,” such as new government regulation, most CPAs know from experience that many industries in general eventually evolve from times of high growth to moderate growth. These conditions mean that firms need to manage their practices smarter and work harder to maintain historical profitability.
This article is based on a management theory developed more than three decades ago by Harvard professor Michael E. Porter to examine forces in the business valuation practice area (see “How Competitive Forces Shape Strategy,” Harvard Business Review, March-April 1979, page 137). The basic idea is to study an industry in five areas: threat of new entrants; bargaining power of buyers; threat of substitute products or services; bargaining power of suppliers; and rivalry among existing firms. Each area exerts a “force” on every player in a particular industry. Every commercial enterprise in an industry is affected by these five forces to some degree. Knowing the strongest forces in an industry allows managers to identify the most important factors affecting their firms and to understand the profitability of firms operating in that domain. (Profitability in this sense means the rate of return on invested capital.)
To better understand the forces affecting each part of their firm, managers should think of the firm as being made up of business segments—such as auditing, tax compliance, and separate areas of consulting services—and look at each segment as part of a larger “industry” made up of many competitors. For instance, there is a tax preparation industry and an IT consulting industry, and each one is made up of many kinds of firms.
While this article focuses on analyzing the business valuation environment, senior managers in any type of firm can use the same technique to analyze different practice areas. Armed with this insight, they can position themselves defensively against competitive forces, influence those forces in some cases, and anticipate shifts that might help them gain a strategic advantage over competitors.
CHANGES FACING THE BUSINESS VALUATION SERVICE AREA
According to Porter, some fundamental changes are likely to occur within mature professions, such as the business valuation niche. Forward-looking managers should recognize that some or all of the following will likely occur in the future or are already affecting the profession:
- More intense competition for market share.
- More selling to experienced, repeat buyers.
- Competitive focus shifting toward price and service.
- Cautious additions to capacity and personnel.
- Reorientation of a firm’s production processes, marketing and selling.
- International competition increases caused by standardization and price pressure.
- Industry profits falling during the transition to maturity, a change that may be either temporary or permanent.
How each firm reacts depends on its individual goals, resources, willingness to change and aversion to risk. Firms may, for instance, need to modify their marketing strategy, enhance client service and more carefully manage operations and financial performance.
THE FIVE COMPETITIVE FORCES
Force 1: Threat of Entry of New Competitors
One factor in this force is barriers to entry into an industry. Like most professional services, business valuation is a knowledge-based service and, thus, providers need to possess a level of technical knowledge to be in the business. Until about 15 years ago, formal business valuation education was obtained by attending a series of seminars over 18 to 24 months to learn the fundamentals and working several years to gain experience. These sorts of activities took time and money. In recent years, it has become easier and less costly to obtain training and a specialty certification. Consequently, it has become easier for new practitioners to enter business valuation, and the number of competitors has grown significantly.
Approximately 4,100 practitioners in 2000 held one or more of the following credentials: Accredited in Business Valuation (ABV) of the AICPA; Accredited Senior Appraiser (ASA) of the American Society of Appraisers; or Certified Valuation Analyst (CVA) or Accredited Valuation Analyst (AVA) of the National Association of Certified Valuation Analysts (NACVA). These numbers reflect the total number of certifications issued by these organizations combined, and some practitioners have multiple certifications. (Note: The Institute of Business Appraisers was unable to provide historical information.) In 2005, 6,600 practitioners held one or more of these credentials; by 2010, that number had grown to 9,700. Moreover, clients have a more difficult time assessing valuation expertise among many practitioners, intensifying competition further.
These conditions have changed the economics of this business segment. To complicate matters, some clients wrongly perceive certain kinds of valuation services as commodities that yield identical results regardless of the valuation provider. As a result, these clients base their buying decisions mostly on price. “Heightened competition has resulted in commodity pricing in many valuation areas such as for estate and gift taxation,” said Robin Taylor, CPA/ABV, a partner with Dixon Hughes PLLC in Birmingham, Ala., and immediate past chair of the AICPA Business Valuation Committee. “This is also true in many kinds of smaller engagements. Price has become the most important point for clients in some areas of valuation.” Perhaps the only action practitioners can take is to educate prospects that training and experience matter and valuation outcomes are not identical.
While competition generally is good for customers, it can cause side effects. Lower prices tend to force practitioners to find more efficient ways to produce their services. “The challenge for them is providing services in less time without sacrificing quality,” says Gary Trugman, CPA/ABV, a partner with Trugman Valuation Associates in Plantation, Fla., and a JofA editorial adviser. Trugman believes there are two aspects of intense competition. “I believe that competition is generally a good thing, and there has been an influx of competition in this area. New firms and professionals entering this niche should be careful not to lowball fees at the sacrifice of quality work for clients.” Practitioners should also be alert to meeting professional standards as they seek more efficient ways to work.
A second factor in this industry force is the amount of investment needed to enter the industry. In earlier years, more serious valuation practitioners needed to spend $10,000 to $20,000 per year for a library including subscriptions. Now, practitioners can get the same sort of information from data suppliers charging lower subscription rates (as a result of competition in publishing) or even low per-use fees. Consequently, it is less costly and not as risky for practitioners to start offering valuation services on a part-time basis, which also lowers barriers to entry.
Force 2: Bargaining Power of Customers
A factor in this second force is buyer price sensitivity. In the current weak economic conditions, clients naturally look for ways to reduce costs. Consequently, they take more time seeking lower-cost valuation services, or they avoid buying the services altogether. Steven Sacks, CPA, executive director of the 56-member accounting-firm association Moore Stephens North America and a JofA editorial adviser, observed, “Before the recession, clients were a lot more relaxed on fees, particularly for nontraditional services. Now, if they want a valuation, clients engage in more rigorous fee negotiations.”
In contrast, when clients need highly specialized or complex valuation services where competition is lower, such as in the health care industry and for litigation, client bargaining power is weaker.
“Because I work in health care, we are somewhat buffered from the turbulent economy since many health care valuations are driven by a highly regulated environment,” said Knoxville, Tenn.-based Carol Carden, CPA/ABV, a shareholder with Pershing Yoakley & Associates PC and chair of the AICPA’s Business Valuation Committee.
Harold Martin, CPA/ABV, a principal with Keiter Stephens in its Richmond, Va., office, agrees about specialization. “With respect to more complex valuations, knowledgeable clients are still willing to pay for the perceived quality offered by more experienced practitioners,” he said.
This part of the analysis shows that the valuation profession seems to have evolved into two types of service providers who could be described as generalists and specialists. Nancy Fannon, CPA/ABV, of Fannon Valuation Group in Portland, Maine, agrees. “On the one hand are the most significant numbers of valuators, from whom the market demands valuation on a highly price-competitive level,” she said. “On the other hand, the more experienced practitioners tend to be more specialized.”
Another factor is the degree of repeat customers. In the business valuation profession, many clients are not repeat buyers. These types of clients only need one-time consulting projects. In this context, clients do not have a lot of power to negotiate lower fees, all other things being equal. Repeat business stems from clients’ needing periodic valuation services for financial reporting or for ESOPs, or lawyers who refer multiple matters. These clients may be in a position to negotiate lower fees since service providers desire a continuing relationship.
But repeat customers do not necessarily mean lower profits. If practitioners can develop a reputation that brings back clients that are in a particular industry or technical area such as health care or bankruptcy, firms can increase their production efficiency through specialization.
Force 3: Threats of Substitute Services (or Products)
This force considers “substitute” products and services that are available to customers. Buyers of valuation services have two obvious alternatives. First, under some circumstances, clients may be more willing to accept a limited “calculation engagement” rather than a more comprehensive “valuation engagement.” Clients are more sensitive to fees in the current economy, and if circumstances allow, they may choose a more limited analysis with a lower price.
SSVS NO. 1
“Valuation engagement” and “calculation engagement” are defined in AICPA Statement on Standards for Valuation Services (SSVS) no. 1, Valuation of a Business, Business Ownership Interest, Security, or Intangible Asset, available at aicpa.org/bvstandard. Calculation engagements require fewer procedures and, thus, are less costly for clients.
“I’ve suggested a calculation engagement if I felt it would suffice,” said Kevin Yeanoplos, CPA/ABV, of Brueggeman and Johnson Yeanoplos PC in Tucson, Ariz., and a JofA editorial adviser.
Indianapolis-based Jim Alerding, CPA/ABV, of Clifton Gunderson LLP, agrees. “I find more acceptance of calculations, especially in family law and some other litigation settings where both sides agree that calculations are good enough,” he said.
A second alternative clients have is simply not getting a valuation and making decisions without that knowledge. By viewing these two alternatives as substitutes, clients can sometimes move away from paying for a comprehensive valuation analysis. If clients have more options, they have more bargaining power when it comes to negotiating with service providers.
Force 4: Intensity of Competitive Rivalry
This force considers whether industry incumbents tend to react to the actions taken by competitors. In the airline industry, when one airline lowers fares, its competitors quickly follow. When competitive rivalry is intense, an industry is considered less attractive by its players. But this sort of rivalry is not limited to price. Other dimensions include quality and innovation.
In relation to the effect of this force on valuation services, there does not seem to be intense rivalry over prices since fees are generally not advertised. However, firms are becoming more innovative and developing new production processes built on their unique synergies, economies of scale and overseas outsourcing.
For example, in 2010, Morningstar started offering business valuation services. In the past, industry incumbents have generally been professional service firms and investment bankers. Morningstar, however, is a NASDAQ-traded investment research company with annual sales of about $500 million and is breaking new ground as a different kind of firm in the valuation industry.
According to Alfonso Ventoso, Morningstar’s director of valuation services who holds the Chartered Financial Analyst (CFA) certification, the company spotted two opportunities: first, to take advantage of situations where auditors have conflicts and, thus, cannot provide valuation services to their clients; and, second, to exploit its intellectual property and size. The valuation industry “is headed towards standardization in terms of content, techniques and designations both domestically and internationally. ‘Dabblers’ are already beginning to be left behind,” Ventoso said. “[Morningstar is] well positioned to take advantage of these trends as the profession matures.”
Some firms are changing their production processes by outsourcing valuation work overseas where costs are lower. Seattle-based Neil Beaton, CPA/ABV, U.S. partner-in-charge of valuation services for Grant Thornton LLP, has seen three organizations in the U.S. that have outsourced valuations of restricted (“cheap”) stock to overseas analysts. Two organizations were valuation shops, and the other was a bank. But Beaton observed that the outsourced reports he reviewed tended to be mechanical and demonstrated less-than-sound professional judgment.
Whether innovations in production processes that include unique synergies, economies of scale and overseas outsourcing are limited situations or industry trends is anybody’s guess. Regardless, it is something for managing partners and practice leaders to watch because it might affect the industry in the future.
Force 5: Bargaining Power of Suppliers
In professional services like valuation, the most important “suppliers” to industry incumbents are the professional employees providing the services. In the current economic climate, more of these sorts of people in valuation are generally available for hire in larger employment markets, and salary costs are not rising like they were before the recession. Consequently, firms are better able to predict their labor costs and head count. However, valuation areas that are highly specialized, such as financial reporting, litigation and health care, still have shortages.
FIRM STRATEGIC PLANNING AND DECISION MAKING
Porter suggests in his 1980 book Competitive Strategy: Techniques for Analyzing Industries and Competitors that, to cope with the five competitive forces, firms have three possible general strategies that might lead to above-average performance within an industry. Managers can adapt these general strategies and implement them according to the specific situation.
- Differentiation. This strategy means a firm is able to differentiate its services as unique (for instance, valuations in large lawsuits where the stakes are high). This strategy provides insulation from some of the forces and leads to higher margins.
- Focus. When a firm is successful with this strategy, it focuses on a particular group of clients (such as the health care industry), a particular type of service (like estate and gift tax valuations) or a particular geographic market. The core idea is that a firm is able to narrow its focus to become more efficient or effective than its competitors.
- Cost leadership. This strategy can lead to above-average profits if a firm can build processes and volume that result in lower unit costs to produce goods and services compared to competitors. This strategy is challenging in professional services, but it is plausible for larger organizations if they are able to lower production costs by increasing efficiency.
Proactive firms will work harder to market their services with attention paid to existing clients and referral sources. Generalists face mounting fee pressures and, thus, need to decide on their negotiating position and limits. In contrast, highly specialized valuation practitioners may be able to maintain their returns and, thus, those firms might devote their attention to their valuation niches. Moreover, generalists could specialize and move away from more competitive areas. Another tactic is working harder on client service—meeting or exceeding client expectations to earn future business or recommendations. Further, in addition to focusing on selling and marketing processes, managers ought to examine their internal production processes so they can perform their work more efficiently.
Times have changed, and firm managers need to change with them or face falling returns. Strategic planning starts with understanding the environment in which a firm operates. The analytical framework discussed in this article offers a straightforward way to undertake this kind of study and begin the planning process.
Managing partners and practice leaders who are responsible for leading their firms can use a straightforward analytical framework to understand their business environment to make better strategic decisions.
This article uses a management theory to analyze business valuation services, but this kind of analysis can be used in every service segment of an accounting firm such as audit, tax, and IT consulting to help managers better plan their firm’s strategy and allocate resources.
Competition has intensified in the business valuation service area and is affecting the economics of what has historically been a profitable niche. It is easier to obtain a certification in this area than it once was, and it is less costly and not as risky for practitioners to offer valuation services on a part-time basis. Clients have difficulty assessing valuation expertise among practitioners, further intensifying competition.
In tough economic times, clients are more proactive in seeking lower costs for valuation services, or they avoid buying the services altogether. The valuation industry seems to be evolving into two service areas: providers of specialized valuations and generalists. Depending on the type of valuation needed, clients may be in a stronger position to negotiate a lower fee.
With clients more sensitive to fees, they may be more willing to accept a limited calculation engagement rather than a comprehensive valuation engagement. A limited analysis means lower cost. Clients also may forgo a valuation entirely.
Some industries, such as the airline industry, are more competitive when it comes to changing fees/fares. Competitive rivalry is not intense in this sense in the business valuation practice area. But newcomers, such as Morningstar, may be changing the playing field to some degree. Some organizations are also starting to outsource their valuations overseas at lower costs.
Labor is a major cost for CPA firms, and currently there are more CPAs available to provide general types of valuation services.
Michael A. Crain (firstname.lastname@example.org) is a principal of The Financial Valuation Group in Fort Lauderdale, Fla. He is also a JofA editorial adviser.
To comment on this article or to suggest an idea for another article, contact Loanna Overcash, senior editor, at email@example.com or 919-402-4462.
Management of an Accounting Practice Handbook (#090407)
- ABV Examination Review Course (#745791)
- Introduction to Business Valuation (#745781)
- Understanding Business Valuation (#732884)
For more information or to make a purchase, go to cpa2biz.com or call the Institute at 888-777-7077.
FVS Section and ABV credential
Membership in the Forensic and Valuation Services (FVS) Section provides access to numerous specialized resources in the forensic and valuation services discipline areas, including practice guides, and exclusive member discounts for products and events. Visit the FVS Center at aicpa.org/FVS. Members with a specialization in business valuation may be interested in applying for the Accredited in Business Valuation (ABV) credential. Information about the ABV credential program is available at aicpa.org/ABV.
- “The Five Competitive Forces That Shape Strategy,” Harvard Business Review, by Michael E. Porter, January 2008, page 78
- “How Competitive Forces Shape Strategy,” Harvard Business Review, by Michael E. Porter, March-April 1979, page 137
Competitive Strategy: Techniques for Analyzing Industries and Competitors , by Michael E. Porter, The Free Press, New York City, 1980
More from the JofA: