Business Valuation Fundamentals for the Construction Industry
There are several reasons the owner of a construction company may require a business valuation, the most common being a potential sale of the business. Other reasons may include gifting stock to family members, funding phantom stock plans, and succession planning. Although the reasons for the valuations are different, determining the correct value is critical in all of them.
Generally, there are three approaches to valuing a business, the Market Approach, Asset Approach, and Income Approach. Below each method will be discussed in greater detail.
People are the most familiar with the Market Approach. It looks and feels similar to “comps” a realtor might use to help determine the value of someone’s home. Rather than using comparable home sales, the Market Approach is based on pricing multiples derived from transactional data of comparable company sales. Those multiples can be based on earnings before interest and taxes, depreciation, and amortization (EBITDA), seller’s discretionary cash flow, and operating gross cash flows. However, obtaining information on relevant transaction (geographic and size) in the construction industry can prove to be difficult. The Market Approach should be considered but is generally not the most appropriate method in determining the value of a contractors’ business.
The Asset Approach is typically the simplest, and for some contractors the most accurate. The Asset Approach is defined in the International Glossary of Business Valuation Terms as “a general way of determining a value indication of a business, business ownership interest, or security using one or more methods based on the value of the assets net of liabilities,” or put more simply, assets minus liabilities. For contractors who have a considerable amount of equipment and who acquire work through competitive bidding, the asset approach may yield the highest value. Tangible assets like equipment and real estate will need to appraised and an adjustment will need to be made to reflect the fair market value of those assets. Once the fair market value adjustments for the tangible assets are made, the last step is to subtract liabilities from the adjusted assets to get the adjusted book value.
The Income Approach converts anticipated economic benefit into a present single dollar amount. This approach is most relevant to contractors who are relatively light on fixed assets but have demonstrated a history of strong earnings. This would likely be the best approach for a construction manager who subcontracts out most of the project.
The two most common ways to determine the value of a company using the Income Approach is the discounted cashflow method or the capitalization of earnings method.
For newer companies that are experiencing tremendous growth, the discounted cash method is the most appropriate. The previous year’s cashflows may not be reflective of the future. The valuation professional will discount future flows to today’s dollars using a discount rated based on the risk fundamental to that company.
For contractors that have been in business for several years and a history of consistent earnings, the capitalization of earning method is the most applicable. This approach takes a company’s historical cashflow and capitalizes it. An average annual earnings stream will be created, and then divided by a capitalization rate that reflects risk and future growth to determine a value.
Performing a valuation for a contractor is as much an art as it is a science. The Market Approach, Asset Approach, and Income Approach are three main approaches used by valuation professionals. It takes a considerable amount of judgement by the valuation professional and an understanding of the industry being evaluated to determine which approach will arrive at the correct value. For contractors looking to achieve the highest valuation possible, strong earnings over an extended period will be paramount.
If you have additional questions regarding business valuation in the construction industry contract Chuck Fenske, CVA (firstname.lastname@example.org).