Construction firm owners are no different from any other business owner when it comes to wanting to know their business’s value. Whether it’s for a potential sale of the business or establishing a value for gift and estate taxes, securing a formal business valuation is critical.
There are several common methods for determining value and financial and non-financial factors that have real and measurable impacts on the value of a business.
Two terms that are essential to business valuation are market value and enterprise value. Think of market value as analogous to the quoted price of a share of publicly traded stock. It is a value that represents the price at which two unrelated parties would be willing to exchange a good. The market value of a share of publicly traded stock is the last price at which a transaction involving that stock took place. Enterprise value is the market value of a company’s equity and debt less the company’s cash. There is often a difference between enterprise value and the value that an owner would receive when selling an ownership interest.
It’s All Relative
C.S. Lewis once said, “The architects tell us that nothing is great or small save by position.” What better way to find the value of a thing than to compare and contrast it with the value of another similar thing? To that end, there is the Capitalization of Earnings Method of valuation. The basic mechanics of the capitalization of earnings method are very simple:
- determine a financial metric;
- determine a suitable market-based multiple; and
- multiply the metric and multiple together.
It may sound simple, but it’s not. The first step in the Capitalization of Earnings Method is to determine an appropriate financial metric to use. The most common metrics are revenue or sales, operating income and an acronym known as EBITDA, which stands for earnings before interest, taxes, depreciation and amortization.
More simply, EBITDA is used as a proxy for the business’s cash flow generation. Just how asset-intensive a business is generally determines which of these financial metrics is the most meaningful for valuation purposes. Of course, no business valuation would be complete without a long discussion about what actually constitutes operating earnings or EBITDA. Believe it or not, there are almost as many answers to this question as there are people discussing the matter.
Once financial metrics are determined, it’s time to determine a suitable market-based multiple. Depending on the purpose of the business valuation, there are a few different sources of market data from which to derive a suitable multiple. The two sources of market data that are widely available are public company financial data and public transaction data. In either case, the end goal is to isolate a list of public companies or transactions that are similar from an operational, geographic, business risk and size perspective.
Using publicly available valuation figures and financial metrics (generally from public filing documents, press releases and public markets data), a multiple for each public company or transaction that represents a ratio of enterprise value to financial metric can be derived.
From that range of multiples, select an average or median multiple and then make adjustments based on company-specific operational or market factors. Once the multiple is selected, the enterprise value can be calculated using a simple multiplication.
Giveth and Taketh Away
Arguably, the most difficult part of the valuation exercise is the selection, adjustment and, most importantly, justification of the suitable market multiple to apply to the company’s financial metric. In many instances, there is a counterparty (e.g., a potential buyer or seller, the IRS or an attorney) involved in the valuation. These counterparties will expect a logically justified and supported valuation analysis. A great deal of thought should be given to each adjustment that is made regarding the selected market multiple.
Generally, adjustments are made based on a combination of financial and non-financial factors in the form of value adders and detractors. Even though the Capitalization of Earnings Method only uses a single financial metric to determine enterprise value, there are financial considerations that can justify a higher or lower market multiple. They are:
The two most common financial value adders are relative profitability and growth. Depending on how the company’s profitability and growth compare to that of similar companies, upward adjustments to the market multiple can be applied.
For construction companies, several factors can be used to justify an upward adjustment in the market multiple. Self-perform capabilities, project size capabilities, project pipeline, backlog, flexibility (ability to travel), special relationships with suppliers or customers, integration across multiple disciplines (if applicable) and the depth of company management could all support a higher company valuation.
Excessive use of financial leverage (i.e., high relative debt levels), excessive use of operating leverage (i.e., an inefficient capital program), and below-average margin or growth figures can all contribute to a downward adjustment to the market multiple.
For companies in the construction industry, several factors can be used to justify a downward adjustment in the market multiple. These factors include concentration of risk in certain key segments, customers or geographies, backlog and lack of integration or capabilities compared to peer companies. A significant value detractor also can come in the form of a lack of organizational depth. With closely held private companies, there can be a tendency to overlook the importance of developing a successor management team with the knowledge and experience to grow the business once the founder or longtime owner decides to exit the business.
Note that backlog was listed as both a value adder and a value detractor. Backlog is an interesting factor that can be both helpful and harmful. On a positive side, backlog represents revenue that the business will likely earn. On the negative side, the terms of the contract that gave rise to that backlog are set and profitability depends on efficient project completion. The nature of backlog is different for each company, so it’s important to consider which specific projects are in backlog to determine how they impact value.
I Was Told There Would Be No Math!
Exhibit 1 is an example of the Capitalization of Earnings Method to value a privately held industrial contractor called Best Construction, Inc., which reported 2014 EBITDA of $500. Based on a company search, three public companies that perform that same mix of work and operate in the same geographic region as Best were identified. Using public filing data, 2014 EBITDA multiples were derived for each of those companies as shown below. For the valuation, the average multiple of 5.6x was selected as a starting place.
The financial and operational characteristics of Best Construction were then considered. Based on the assessment of some of the value adders and detractors, adjustments were made to arrive at the market multiple. Lastly, multiply suitable market multiple by Best Construction’s financial metric to arrive at an estimate of Enterprise Value.
Of course, this is a simplified example, and considerably more analysis can be performed to support the selected public companies and the adjustments made to the market multiple.
More Art than Science
At the end of the day, business valuation is more of an art than a science. However, having some familiarity with the “science” aspect will help a contractor be prepared to support and justify the company’s maximum value.