3 primary approaches to take right now to prepare for the future

Whether you are currently in the process of retiring or selling your business, or it is just a thought a few years away, the first step is to determine the value of your company.

Business owners often make the mistake of not fully understanding the total value of their company. Owners tend to rely on anecdotal information to determine the value of their business, such as the price at which a competitor recently sold his business. This can lead to disappointment at the exit or even the late realization that an exit is not possible, with lower-than-expected proceeds from a sale resulting in the inability to fund retirement. Often, owners discover that the value they thought the business had is nowhere close to what the market is actually willing to offer.

These are all reasons why it is critically important to regularly value your business. In fact, it is strongly recommended that you consider having an independent valuation performed on your business prior to marketing it for sale.

While there are no hard and fast rules that one should use to value a business, there are several methodologies that are commonly used. Understanding common methodologies can help you better understand your business's value. Consider the following three primary approaches to valuing a business.

Income Approach

Companies in the construction sector exhibit much greater volatility in operating performance than companies in other industries. As a result, it can be much harder to predict future performance. In fact, it is very difficult to predict financial performance more than one year ahead. Therefore, when applying an income approach to a construction company, we generally use an income capitalization method that considers historical results, rather than a method that is based on projected cash flows. The income capitalization method involves two variables:

  1. Income or cash flow stream to be capitalized
  2. Capitalization rate that is used to convert the cash flow stream to a value

Cash flow = Value
Capitalization rate

The cash flow stream in this formula is stated as a single dollar amount that is assumed to be consistent each year. Recent historical results (with normalizing adjustments) are often used to indicate cash flow levels that can reasonably be expected in the future. Weightings are applied to the adjusted historical results (as well as the projection for the upcoming year to incorporate existing backlog), and the weighted average of the results is used as the cash flow stream to be capitalized.

A capitalization rate is selected, which represents an investor's required rate of return on an investment with a similar degree of risk. This capitalization rate is developed by estimating the company's weighted average cost of capital (WACC), and then subtracting the expected rate of future growth.

Market Approach

In this approach, the value of a business is determined by using one or more methods that compare the subject company to similar businesses or to securities of similar businesses that have been sold. Ratios commonly used for comparison are Enterprise Value (EV, the sum of a company's equity and net debt) to revenue and EV to EBITDA (earnings before interest, taxes, depreciation and amortization). This approach examines factors, such as:

  • Guideline businesses which have recently been sold
  • Publicly traded stocks of companies that participate in the same general line of business

Multiples typically observed in construction are much lower than those observed for other industries due to the nature of the work, which is project based, and the volatility caused by fluctuations in the number of projects and project size.

Asset Approach

Under this method, the value is determined by considering the value of the business's individual assets and liabilities. Each component of the business is valued separately. The values are totaled and reduced by outstanding liabilities to determine the net asset value of the company.

However, the asset approach is often not very applicable in the construction industry, particularly for general contractors and A/E firms that have little tangible value outside of net working capital.

In fact, for profitable general contractors or A/E firms, the asset approach should only be used as a reasonableness check, or, at minimum, that the resultant value from an income approach or market approach should not go below.

For subcontractors that are more equipment intensive, the asset approach may be more relevant, particularly if the company does not have a history of consistent profitability.

Factors That Can Increase Value

Regardless of the approach used, several factors have an impact on the resulting value of a company:

  • Growth—Companies that have consistently achieved higher growth or are expected to achieve higher growth will typically enjoy a premium valuation.
  • Profitability—Companies that enjoy higher profitability will also achieve a higher valuation.
  • Size—Larger companies will typically receive higher valuations, as larger size tends to be correlated with lower risk.
  • Lower volatility—Companies with consistent operating performance and low volatility will typically enjoy higher valuations.
  • Synergies—When several potential buyers can achieve synergistic benefits from the purchase of a company, the company will achieve a higher valuation, all else equal.
  • Interest rate environment—In a low interest rate environment, potential alternative investments, such as fixed income investments, are less attractive. This causes equity or company valuations to increase.

For construction companies, additional elements, such as backlog, brand strength and reputation, diversification (geographic and project type), specialty focus (higher profitability for niche work) and strong client relationships tend to lead to a higher valuation. The point in the business cycle also can be critical, as construction companies tend to be very economically sensitive. When the overall economy is approaching an expansion, the long-term growth rate used in the income capitalization approach will be higher, and the revenue or EBITDA multiple applied will increase, resulting in a higher value.

The volatility and economic sensitivity of construction companies can make them difficult to value. However, having a valuation framework in hand before you approach a potential buyer is simply smart business. An independent valuation can help provide a clear roadmap for a successful sale, provide some peace of mind and put you in a stronger bargaining position when a potential buyer calls.