by Robert Gross
November 2, 2011

As the owner of a construction-related business, appraising your company's worth might do more than just satisfy your curiosity.

In fact, there is a strong case that it is perhaps one of the most important things you can do to increase your company's future value and gain a competitive edge. By going through the valuation process, you will come to understand the drivers that both positively and negatively impact value, which will allow you to make any necessary adjustments to help your company better compete and succeed.

If you’re looking to sell your business, initiate a value-based incentive plan or fractional management buyout, or drive value toward a future goal, you need a professional business valuation before ever starting down the path to selling all or part of your business. When considering the value of a construction company, there are three basic components that tend to drive value:

  1. Backlog
  2. Equipment
  3. People

In the case of most general contractors, there isn’t any equipment to take into consideration. Also, as with architectural and engineering firms, most of the construction company’s most valuable assets walk out the door every night. That being the case, what is it that makes one construction company worth more—or less—than any other and how exactly do you determine that difference? Beginning with the premise that the company has some level of backlog, good people working for it and an adequate degree of fixed plant and rolling stock, to determine real value, start by evaluating the elements of uniqueness that set the firm apart from the rest.  In the construction marketplace, the value of a given company can be influenced by a number of variables, both internal and external. In particular, there are departures from simple asset-based valuations in the firm’s ability to adjust to the cyclicality of the industry, its level of specialization, bonding availability, its geography and, obviously, its performance.

Qualities of Uniqueness

Every construction company goes through cycles—it’s the nature of the business. Whether involved in public or private sector building, the level of activity is a function of many external factors outside the control of a given firm. There can be wide swings in revenue and productivity, affecting how the company fares from year to year.  What becomes important from a valuation standpoint is how the company manages this cyclicality—how well it adapts to changes in the external marketplace. The company that better manages the peaks and valleys of the business is obviously worth more in the eyes of a potential buyer. Likewise, because of the attractiveness it might represent to a potential buyer, firms that differentiate themselves through specialization tend to add a great deal of value. As an example, a public sector infrastructure company developed a specialization in minimizing the impact of putting roads and bridges into environmentally sensitive areas such as national forests. Another company, which specializes in constructing cogeneration electric power plants for major utilities, has developed a reputation as being particularly skillful in the installation of a special type of turbine used in the upgrade or modernization of operating power plants. Still another company specializes in retrofitting old buildings in the western United States with seismic damping foundations to better withstand earthquakes. The point is, all of these specializations rely on people with unique skills that drive new business, increase revenues and ultimately add real market value.   However, not all firms specialize. Some very successful construction companies operate much more generally but excel at project management. In that case, valuation might focus more on a company’s ability to attract and retain qualified managers and workers. Project management firms might also hold particular value based on their geographical location and understanding of a local market.

Determining Value

While totaling a company’s asset values and subtracting its liabilities generates a value indication, such an approach fails to reflect the unique, intangible elements of many construction companies. Accordingly, when performing an actual valuation of a construction business, two approaches have evolved that capture both the financial and intangible aspects of the firm: a market comparable approach and an income valuation approach.  The market comparable approach determines a company’s value by comparing it to other, similar firms, while the income valuation approach estimates future economic returns based on current and historic operating performance. It is preferable to use both approaches, but deciding which of the two should carry the most weight depends upon the specific attributes of the individual company and the market in which it operates. A market comparable approach requires determining which comparable public companies and private transactions are most similar to the company in question. The only way to figure that out is to get beyond the oversimplification that all construction companies are the same. As we’ve seen, they’re not the same.  Valuation requires deeply informed research and analysis to understand the economic engines driving a particular construction company. An appraisal must take into account any specialization, project management history, whether the firm operates in the private or public sector and, if within the public sector, to what degree public budgets and planning will affect the company’s level of business over time.  In a market comparable approach, it becomes critical to pick quality, comparable businesses. In construction, this demands a very thorough study of the company and a deep understanding of which sectors are represented by the comparable group. Sometimes it’s difficult to find good comparables to match the uniqueness of the construction company and it might be better to employ the income valuation approach.  

 

The Impact Of Cyclicality

Again, the construction business is one of cycles. The danger this represents to valuation, whether using a market comparable or income valuation approach, is in oversimplifying the situational significance of any particular point in time and assuming that trend will continue. It would be inappropriate, in such a cyclical industry, to assume that any peak will continue on indefinitely. In that same vein, if the company is in a trough, with construction business down, it would be equally inappropriate to suggest it will always remain that way.  When valuing construction companies, using either an income valuation approach, which develops future projections of revenue, profitability and cash flow, or a market comparable approach, which examines comparables, it’s wise to look back over several years’ performance. Then, taking into account average levels of profitability and performance over a longer period of time, try to understand where the company is in a particular cycle.  This commonly understood cyclicality is why construction company valuations tend not to ratchet up as high in an industry peak and not fall as far down in a trough. That cyclicality must become a driver in the construction of any valuation modeling that seeks to mimic the marketplace and determine how hard-dollar investors would be handicapping that sort of performance.   The same concept applies from an income valuation approach standpoint. Assuming a rapid run-up in revenue—such as we often saw between 2002 and 2006—will continue moving forward when doing projections is probably a very dangerous oversimplification. Another issue with an income approach—just as a practical matter—is that construction companies generally are not positioned to make long-term projections about future business.  Typically, looking at a company’s backlog, extending it forward and estimating repeat business, gives, at best, an incomplete picture of future performance. While an income valuation approach in other industries might operate in terms of five- and ten-year-outlooks, construction companies might not know what's going to happen over the next nine to fifteen months, let alone two years or beyond. It makes much more sense to look backward, find periods of sustainable profitability and use that as a sensible way of looking forward, instead of trying to project specific peaks and valleys in the future.

Reasons for Valuation

There are many reasons to perform a valuation of a construction business, but the most common is an ownership transition. Before the company proceeds with ownership transition—whether fractional management buyouts, employee stock ownership plans (ESOPs), equity incentives or outright acquisition—the most basic requirement is an accurate understanding of the company’s value.  There's a natural tendency in the construction industry for companies to have successor managers. The people who come up through the ranks, become senior project managers and take on responsibility for certain parts of the business are often capable of being the next generation of ownership. While they will likely not have the capital to purchase the company, there are other ways to structure an ownership transition internally that make a particularly good fit for construction firms.  Valuations can also help owners determine what can be done to drive or improve on the value of their businesses. Key construction industry performance indicators—backlog trends, staff utilization, job margins, receivables matching capital expenditures, level of rework, etc.—become clearly connected to value. The review of the valuation becomes the language in which the company’s performance is assessed among the senior leaders at the company. Making the connection between performance and value is something that can only really happen once a valuation has been done.   There are situations where valuation is required by law for companies that have to deliver a conclusion of value to particular stakeholders every year—with an ESOP, for example—or when required by shareholder agreements. Also, any company creating real or synthetic incentive-based ownership plans moving equity stakes to key managers will want to communicate that value somewhat regularly. While the precise periodicity of valuations will depend on the particular company, generally, the more its performance varies from year to year, the more frequent the cycle of valuation should become. Regardless of the motivating factors leading a construction company to perform a valuation, the process itself is perhaps one of the most important things an owner can do to increase future value and gain a competitive edge. By going through the valuation process, you will come to understand the drivers that both positively and negatively impact value. Not only will you learn what your company is worth now, but also how to best maximize its value in the future. 

 

Construction Business Owners, June 2008