Understanding Discounted Cash Flow: Merchant Portfolio Valuation

Introduction

The payment processing ecosystem is complex and nuanced. Historically, understanding the realistic value of a merchant portfolio was tedious and convoluted. Yet, proper valuation is crucial for investors, financial analysts, and business owners alike, providing a clear picture of a portfolio's worth and informing strategic decisions ranging from mergers and acquisitions to growth strategies and enterprise planning. Establishing the importance of knowing the value of your portfolio is simple; the practice of measuring the value, however, is significantly more byzantine. Further complicating matters is the fact that the payment processing industry is a sector widely known for its dynamic nature and rapid change. Accordingly, this monumental task is one that puzzles even professionals across the entire industry, with no clear-cut solution.

Enter Rezidual A.I., a SaaS-based payments-specific solution that serves as a beacon of clarity in the previously opaque and frequently unreliable art of payment asset valuation. Rezidual A.I.'s proprietary tools allow users to remove the uncertainty around valuation, breaking it down into the fundamental components and delivering intuitive, simple results. It is a solid foundation for informed decision-making. Its application across the industry is particularly timely and important, given the pervasive problems of information asymmetry, lack of standardization, and variable nomenclature that have plagued the true process of analyzing and properly valuing payment assets.

Rezidual A.I. fuses its proprietary set of portfolio analytics, developed and battle-tested by payments industry veterans, with a uniquely designed payment-specific Discounted Cash Flow (“DCF”) module to provide an unrivaled view into a payment asset’s value, both at the macro level and broken down into its component parts of risk and KPIs, respectively.

As we delve deeper into the gradations of payments-specific Discounted Cash Flow analysis and its application in merchant portfolio valuation, keep in mind that this is more than just a financial exercise—it's a strategic tool that can unlock a deeper understanding of value creation in the payment processing industry.

What Is Discounted Cash Flow (“DCF”)

At its core, Discounted Cash Flow is an appraisal method used to estimate the value of an investment based on its expected future cash flows. Specifically, the present value of an investment is equal to the sum of its future cash flows, discounted back to its present value. This principle underscores the time value of money, recognizing that a dollar today is worth more than a dollar tomorrow due to its potential earning capacity. This method quantifies the Net Present Value (“NPV”) and Internal Rate of Return (“IRR”) generated by a stream of future cash flows. The IRR is an implied value where the sum of all future cash flows, when discounted by this rate, are equal to zero. The model depends on a Discount, or “Hurdle”, rate, to derive the present value of each explicit future period. Comparing the IRR, or return rate where all cash flows are equal to zero in present terms, to the Hurdle Rate, will inform a decision-maker whether the project is attractive or not. If the Hurdle Rate exceeds the Discount Rate, then the project is favorable and will produce a positive NPV. If not, then the project is unfavorable and will produce a negative NPV. In understanding this dynamic, it becomes apparent why the discount rate is critically important - it represents the “opportunity cost” or the risk tolerance of deploying cash into a project, such as acquiring a payment asset. The higher the risk, the higher the Hurdle Rate, and therefore the higher the future cash flows must be to justify the inherent risk.

This approach is fundamental to financial modeling and valuation, serving as a critical tool for analysts, investors, and executives who seek to determine the intrinsic value of assets, including entire companies or specific investment opportunities within the payment processing sector. 

Given the recurring nature of payment assets, the DCF approach is an ideal methodology. In theory, it should be simple for someone to determine the current residual, anticipate the change over a specific period of time, and then apply the basic logic of the DCF to determine the value. However, in practice, it is far more complicated as there are myriad factors that influence the future cash flows associated with merchant residual income, and getting a single component incorrect can drastically affect the outputs of the model.

Let’s briefly review the process to highlight this convolution. In summary, the calculation involves two key components:

1. Forecasting Future Cash Flows: This requires a detailed analysis to estimate the amount of cash an investment will produce in the future, taking into account revenue growth, operating costs, taxes, and any other factors that could affect cash flow.
2. Determining the Discount Rate: The choice of discount rate is critical, as it reflects both the risk of the investment and the return that investors require. It often includes the risk-free rate plus a risk premium that varies depending on the investment's volatility.

Forecasting future cash flows may sound simple, but it’s not quite as easy as just picking a growth rate and hoping for the best. One must consider a number of key variables that affect the future cash flows of recurring income assets, such as payments assets:

• Attrition: This represents the inherent and natural loss of individual accounts from a merchant portfolio that is present in nearly every payment asset in existence. One must consider both the methodology (there are many flawed and biased techniques that don’t accurately reflect attrition) as well as the layer or prism through which attrition is viewed. We will delve deeper into this concept more in this series.
• Same Stores Sales / Seasonality: All merchant portfolios go through natural ebbs and flows as the unique composition of businesses comprising the portfolio undergo changes; revenue growth, seasonality, economic cycles, etc. These all bear influence on the residual cash flow, given its high sensitivity to fluctuations in sales volume and transaction count.
• Yield: The industry constantly faces margin compression, and thus every merchant portfolio deals with natural variability in residual income yield (measured as the ratio of income to sales volume). Additionally, yield is influenced heavily by merchant industry categories, known as MCC/SIC codes, and by the degree to which payments are integrated with other value-added products and services.
• Merchant Unit Economics: The profile of an average merchant can change dramatically, even while the aggregate portfolio may only experience microscopic changes. This can lay the foundation for meaningful changes over time that can be material to the outcome of the valuation model.

These are just a few examples of the numerous factors that influence the forecasting of future cash flows related to a payments asset. Is your head spinning? Not to worry - Rezidual A.I. performs all of the above analytics (and much more) and automatically interfaces these variables with the forecast so you can be confident your forecast is accurate to your unique enterprise.

Determining a discount rate is another crucial component of the valuation model process. Traditional philosophy recommends that you use your cost of capital (i.e., the opportunity cost of deploying the capital into the project versus other viable options), and in general, that may serve as a good benchmark. However, there are additional layers of risk involved in a payment asset valuation that should be considered when determining an appropriate discount rate.

• Merchant Concentration: this measures the exposure each portfolio has to the most “material” MIDs in the book. Picture the classic Pareto principle (the 80/20 rule), which would state that 80% of the residual is derived from 20% of the MIDs. While the specific thresholds are different and unique to each portfolio, the takeaway is the same - higher merchant concentration suggests an elevated dependence on a small contingent of accounts and thus a higher risk if any one of those accounts attrits.
• MCC Concentration: certain industries present greater financial risk than others, and given that most merchant portfolios have at least some degree of vertical heterogeneity, it is a complicated task to measure the blended risk profile for each unique asset.
• Size and Durability Factors: there are a variety of quantitative measures that feed into the overall composition of the portfolio that relate to size and durability. Understanding how certain KPIs and metrics are indicators of these factors is critical in assessing the intrinsic risk of a merchant portfolio.

Sufficiently spooked yet? Not to worry, the comprehensive analytics reporting of Rezidual A.I. can empower you with all the intelligence you need to properly assess risk and ensure you have an appropriate “margin of safety” as you develop your discount rate assumptions.

The Role of Rezidual A.I. in Perfecting DCF Analysis

Rezidual A.I. was purpose-built by industry veterans with 50+ years of domain-specific expertise in the merchant services industry.  Accordingly, the platform emerges as a powerful ally in addressing the challenges associated with applying a standard DCF to dynamic merchant portfolios. By harnessing advanced analytics and artificial intelligence, Rezidual A.I. offers users an unprecedented level of insight into their portfolio data, enabling more accurate and reliable cash flow projections.

By incorporating a range of analytical indicators into financial planning, the DCF module helps businesses understand the impact of different scenarios on asset pricing and net present value/internal rate of return outcomes. Whether you're a seasoned financial analyst or a business owner seeking to understand the value of your portfolio, Rezidual A.I. equips you with the tools and insights necessary to navigate the valuation process with confidence and precision.

By integrating Rezidual A.I. into their financial workflow, stakeholders can overcome the inherent challenges of implementing a DCF valuation method, ensuring that their capital allocation decisions are based on robust, data-driven analyses and reflect grounded assumptions about their merchant portfolios.

Conclusion

Navigating the complexities of merchant portfolio valuation demands more than mere numerical acumen; it requires a strategic vision underpinned by robust methodologies like Discounted Cash Flow analysis. As we've explored, DCF's relevance in the payment processing industry is underscored by its ability to illuminate the intrinsic value of portfolios, accounting for the multifaceted nature of future earnings. However, the journey to unlock this method's full potential is marked by challenges that demand both analytical sophistication and domain-specific expertise.

Rezidual A.I. is a transformative platform that not only addresses the intricacies of Discounted Cash Flow application but also heralds a new era of democratization of nuanced financial analysis. By augmenting the DCF process with unparalleled data insights and analytics, Rezidual A.I. empowers stakeholders to transcend traditional valuation barriers, fostering strategic decisions imbued with precision and insight. As we stand on the brink of this new frontier, Rezidual A.I. invites stakeholders to reimagine the possibilities of portfolio valuation, promising a future where strategic foresight and financial acumen converge to unlock better capital allocation decisions and new possibilities. 

In an era of hyper-innovation and evolution, embracing the capabilities of Rezidual A.I. should be viewed as not just an option but a strategic necessity. We invite you to explore the platform's potential and discover how it can augment and amplify your managerial decisions, transforming raw data into strategic opportunities all while guiding your journey towards informed, rational, data-driven successful outcomes.

Dive deeper into the transformative potential of Rezidual A.I. for your portfolio valuation needs. Schedule a demo today and see how our platform can revolutionize your approach to financial analysis and strategic decision-making.