How Are Merchant Portfolio Valued?

A merchant portfolio consists of all the merchants that a company has contracted to process payments on its behalf. With thousands of merchants processing millions of transactions every year, merchant portfolios are integral assets for payment service providers and independent sales organizations. So, how are merchant portfolio valued? Let us find out in this article.

Accurately valuing merchant portfolios is key for strategic decisions like acquisitions, divestitures, and financings. However, merchant portfolios are unique assets that don’t trade actively in the open market, making their valuation complex. This article will discuss the main approaches used to value merchant portfolios, including their pros and cons. We will cover the cost approach that values a portfolio based on the costs to recreate it. The income approach that considers the portfolio’s cash flow-generating ability will also be examined. Finally, the market approach that compares to similar portfolios will be outlined. By understanding these valuation methods, companies can make informed decisions regarding their merchant portfolios.

How Are Merchant Portfolio Valued

Cost Approach

The cost approach values a merchant portfolio based on the costs required to recreate or replace it. This approach is based on the principle of substitution, which states that a prudent investor would pay no more for an asset than the cost to duplicate its benefits.

Within the cost approach, valuators use either the reproduction cost or replacement cost basis. The reproduction cost estimates what it would take to recreate an exact replica of the existing portfolio. However, this is rarely relevant since modern technology has advanced significantly.

The replacement cost basis considers what it would cost to build a portfolio with similar functionality, but not necessarily identical. This is often a more practical cost basis. In determining replacement cost, valuators must estimate the costs involved to:

• Onboard new merchants to the portfolio, including application processing, underwriting, and setup

• Negotiate rates and contractual agreements with the new merchants

• Attract the same volume of transactions and revenue as the existing portfolio

• Replace any proprietary software or technology used

While the cost approach provides an objective indication of value using verifiable data, it has limitations. It does not capture the earnings potential and cash flows that drive the portfolio’s true economic value. Additionally, the cost approach assumes efficient markets when merchant portfolios are not actively traded.

Income Approach

The income approach values a merchant portfolio based on its ability to generate cash flows into the future. This approach assumes that a portfolio’s economic value is derived from the income it can produce for its owner.

Within the income approach, there are two main valuation methods: the discounted cash flow (DCF) method and the direct capitalization method.

For the DCF method, valuators first project the future cash flows that the portfolio is expected to generate. This includes income from transaction fees, monthly service charges, and other revenue streams less applicable operating expenses. The projected cash flows incorporate reasonable growth assumptions based on the portfolio’s historical performance, industry trends, and management forecasts.

Next, an appropriate discount rate is selected to determine the present value of the future cash flows. The discount rate should reflect the risks associated with achieving the projected cash flows. Higher risk requires a higher discount rate and vice versa.

Under the direct capitalization method, valuators determine an appropriate capitalization rate based on similar portfolios and market transactions. The capitalization rate captures the relationship between a portfolio’s income and its value. A lower rate indicates higher income relative to value.

The capitalization rate is then applied to the portfolio’s normalized income. This indicates how much an investor would be willing to pay for the income that the portfolio is expected to generate on an annual basis.

While the income approach captures the true economic value of merchant portfolios, it has limitations. Projecting future cash flows requires several assumptions and estimates that introduce error and uncertainty. The selected discount and capitalization rates are also subjective.

Market Approach

The market approach values a merchant portfolio by comparing it to similar portfolios that have been sold recently. This relies on the principle of substitution, which states that prudent investors will not pay more for a portfolio than an equivalent alternative already available on the market.

Within the market approach, valuators use one of three main methods: guideline public company, merger and acquisition comparables, and recent sales comparables.

The guideline public company method compares the subject portfolio to those of similar publicly traded companies. However, very few companies derive the majority of their value from merchant portfolios. Thus, comparability can be limited.

The merger and acquisition method uses portfolio acquisitions by other companies. But these transactions also tend to involve other assets and corporate synergies beyond just the merchant portfolio. Isolating its value can be challenging.

The recent sales comparables method relies on recent transactions of similar merchant portfolios. However, few pure-play portfolio sales occur, limiting the availability of true comparables.

Even when comparable portfolios are identified, adjustments must be made for differences in portfolio size, originations volume, merchant mix, attrition rates, technologies used, and geographies served. These adjustments require subjective judgment.

Despite its limitations, the market approach can still provide a relevant check on the values indicated by the income and cost approaches. When adequate comparable portfolios are available, the market approach uses real transactions to ground the valuation in economic reality.

Combining Valuation Approaches

While each valuation approach has its pros and cons, valuators often combine two or more approaches to determine a final value for a merchant portfolio. By considering multiple indications of value, the result is likely to be more robust and reliable.

When combining approaches, valuators first weigh the strengths and weaknesses of each method based on the available data and portfolio characteristics. The income approach typically receives the most weight since it captures the portfolio’s economic value. However, the cost and market approaches can provide supporting indications and sanity checks.

For example, if adequate comparable portfolios are available, the market approach may receive moderate weighting. If replacement cost data is easily obtainable, the cost approach may be given some consideration.

Next, valuators determine an indication of value from each chosen approach. They may assign a weighting to each indication based on its judged reliability for the specific portfolio. For example, a 50% weighting may be given to the income approach and 25% each to the cost and market approaches.

The weighted values are then combined using a formula. A simple weighted average of the indications can provide an initial combined value. However, valuators also consider qualitative factors and expert judgment to adjust this preliminary value up or down as needed.

Key factors considered include growth prospects, technology differentiation, attrition risks, management quality, and industry trends. The valuator’s experience, knowledge of the market, and insight into the specific portfolio are crucial.

By thoughtfully combining and potentially adjusting the weighted values from each approach, valuators can arrive at a fair value for a merchant portfolio that reasonably considers all available factors. However, the result is still only an estimate based on the input assumptions, data limitations, and expert judgment used. Thus, a flexible approach is needed to value each unique portfolio.

Conclusion

In summary, there are several key approaches that valuators use to determine the value of merchant portfolios, including cost, income, and market approaches. Each one has benefits and limitations based on the available data and portfolio characteristics. By weighting and combining the different approaches appropriately, valuators can arrive at a balanced value indication for a merchant portfolio.

However, valuation is as much art as it is science. Expert judgment, qualitative factors, and a flexible methodology are critical to account for the unique complexities of each portfolio. While valuation estimates provide a useful reference point, companies must ultimately make strategic decisions regarding their portfolios based on a range of commercial and economic considerations. With a full understanding of the pros, cons, and assumptions behind any valuation, these decisions can be made with confidence.