When considering a sale or merger, planning for succession, obtaining financing or making changes to ownership structure, how does a construction executive determine the company’s value?
Determining value can be difficult because traditional valuation methods fail to take into account the value derived from human knowledge and skill, as well as an enterprise’s reputation. While valuations that are critical to the business should always rely on a professional, the following tools are useful in arriving at a general idea of a business’s value.
The three traditional valuation methods include asset-based, market-based and income-based. Regardless of which method is used, it is important for the company to have sufficient financial records, including tax returns, for at least the past five years.
Asset-Based Valuation Is Most Objective
Asset-based valuation is the most objective way to assess the worth of a business. It is the market value of all assets minus all liabilities. Construction companies with significant equipment and facilities often use this valuation method.
Assets of a construction company include notes, accounts receivables, real property, tangible personal property and intangible assets. Financial and tangible assets can be valued at:
- book value, which is the value of the asset as stated in the company’s financial and accounting records;
- adjusted book value, which is the book value adjusted to more accurately reflect the assets’ true market value; and
- liquidated value, which is the value of the assets if the company liquidated immediately.
Liquidated value provides the lowest value of the assets and the adjusted book value generally provides the highest value.
Intangible assets are valued subjectively, and typically include contracts in progress, outstanding contract proposals, brand name recognition, trained workforce, relationships with clients, management employment contracts and important supplier contracts. A construction company that has pending legal issues or unfavorable long-term contracts may have a negative intangible value.
Market-Based Valuation Compares Businesses
Market-based valuation compares a company to similar businesses that have sold in the past. That seems like a good barometer, but the problem is that it’s usually hard for an outsider to find the necessary financial information about closely held companies.
While the comparable companies may differ in important respects, including size, location and market share, their financial ratios speak directly to the value of other companies in the same industry. These ratios often compare the price to earnings, sales, equity and cash flow. These ratios can be very convincing if the information about comparable companies is available.
Income-Based Valuation Looks At Returns
Income-based valuation determines the value based on the company’s expected annual returns. This method often is used by construction companies, particularly general contractors that have few fixed assets and rely significantly on credit.
This is done by two methods. The discounted cash flow method forecasts about five years of future revenue, net income and capital spending, and then determines a current value that is discounted for risk. In the capitalization method, a normalized earnings amount is determined and then divided by a capitalization rate that reflects risk and future growth. The earnings amount used is usually EBITDA, which is earnings before interest, taxes, depreciation and amortization.
While only one of these methods likely will be used to determine the value in a transaction, it can be useful to compare the values obtained in all three methods. Ultimately, the value is whatever a buyer is willing to pay or a lender is willing to accept in financing, but analyzing a business with each method can help owners make the best case for their business.