Key Considerations in Valuing a Construction Company
As the owner of a construction company, there are many possible reasons for needing to know the value of your business. Whether you are contemplating a sale or merger, planning for internal ownership succession, considering gifting stock to family members or obtaining financing, determining what your company is worth is one of the first steps in the process. Just as importantly, understanding how your company is valued can provide valuable insight into the measures that you can undertake to enhance the value of your business over time.
Traditionally, there are three primary approaches to valuing a business:
- Market-based approaches, which look to transactions involving the sale of similar companies in the same line of business in order to derive multiples of sales, earnings or other metrics to apply to the company to be valued.
- Asset-based approaches, which value a business based on the fair market value of its assets less its liabilities
- Income-based approaches, which value a business by looking to the future earnings or cash flows it is expected to generate in the future
Since the majority of construction companies are closely held businesses, obtaining information on transactions that have occurred in the market can prove difficult. So too can obtaining the necessary information to determine the true comparability between two construction companies before applying valuation multiples under the market approach. As a result, most valuations of construction companies focus on either the asset approach or the income approach.
For construction companies with significant equipment and facilities, such as a highway contractor, the asset-based approach may yield the highest value in a transaction. In addition, since many heavy contractors are required to be the low bidder on many of their contracts, they are often poor candidates for employing an income-based approach.
In determining value under an asset approach, the company’s financial assets, such as accounts receivable and unbilled contracts in process are revalued based on the amount that is likely to be realized in cash. Similarly, tangible assets are revalued to their fair market value based on the current cost to acquire or reconstruct a replacement asset of comparable utility. After determining the fair market value of the company’s financial and tangible assets, the existing liabilities of the company are subtracted from this value, resulting in the entity’s Adjusted Book Value.
In some instances where significant intangible assets value may exist in addition to the value of the company’s “hard” assets, these intangible assets may also be separately valued and added to the Adjusted Book Value. Examples of intangible assets include contract backlog, name recognition/reputation, a trained and loyal workforce and strong client and vendor relationships. These intangible assets are generally reflected as “goodwill” in the context of a business valuation. Valuing the goodwill component of a construction company is generally accomplished through an income approach such as the capitalization of earnings.
For general contractors or specialty contractors with fewer assets and a higher reliance on credit, the income-based approach is generally preferred. This approach to valuation is based on the company’s expected future annual returns to an investor. Where reasonable future cash flows of the company can be projected, these future cash flows are converted into current value. This is accomplished by discounting the future cash flows to today’s dollars using a discount rate based on the risk inherent in an investment in the company. In essence, the discount rate reflects a safe rate of return, plus an additional return that will compensate the investor for the risk of actually achieving the projected future cash flows.
As an alternative to discounting future cash flows, historic earnings or cash flows can be adjusted and capitalized. Where earnings are used in lieu of cash flows, the earnings measure most often utilized is EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization). Regardless of the measure used, the company’s historic earnings or cash flows must be “normalized” in order to reflect the benefit stream an investor can expect to receive in the future. Typical normalization adjustments include owner’s compensation and fringe benefits, related party transactions and nonrecurring or extraordinary items. Once an average annual earnings stream has been determined, this amount is converted into value by dividing it by a capitalization rate (a derivative of the discount rate) that reflects risk and future growth.
As you can see, there is no single approach or simple formula to valuing a construction company. Just as every construction company is unique, so too must the analysis of the company be in order to select the best valuation approach, discount or capitalization rate and other valuation adjustments. Engaging a professional with the experience and expertise in valuing entities in the construction industry is critical to arriving at the true value of your company.
If you have any questions or would like more about the Business Valuation services that Dannible & McKee offers, please contact Deborah E. Finch, CPA/ABV, CVA, CDA at (315)472-9127 or email firstname.lastname@example.org.