Comparative methods of valuing
a construction company
How can a construction executive determine a company’s value when considering a merger or acquisition, planning for succession, obtaining financing or making changes to ownership structure?
It can be difficult to determine the value because traditional valuation methods fail to put a price on human knowledge and skill or take account of the enterprise’s reputation. Business should always rely on an accountant or specialised professional to carry out these critical valuations. In the absence of the financial professionals, however, business may employ the following traditional methods to arrive at a rough estimate:
An 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 receivable, 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 unfavourable long-term contracts may have a negative intangible value.
A market-based valuation compares a company to similar businesses that have sold in the past. This would seem a good barometer, except that that it is often difficult for an outsider to access the necessary financial information when companies are closely held.
While the comparable companies may differ in important respects, including size, location and market share, their financial ratios speak directly to the value of their industry peers. These ratios often relate price to earnings, sales, equity and cash flow. Such ratios can be very persuasive provided that good quality information is available.
Income – based valuation
Income-based valuation reflects the value based on the company’s expected annual returns. This method is often employed by construction companies, particularly general contractors who have few fixed assets and rely significantly on credit.
There are two methods:
1) The discounted cash flow method that first forecasts revenue over 5 years along with net income and capital spending, and then determines the current value of those assets adjusted for risk.
2) The capitalization method, where normalized earnings are determined and then divided by a capitalization rate that reflects risk and future growth. The earnings amount used is usually EBITDA, i.e., earnings before interest, taxes, depreciation and amortization.
Often, only one of the above methods is employed in any given transaction, it can be instructive to compare the values obtained under all three methods. Ultimately, the value is whatever a buyer is willing to pay or a lender is willing to accept in financing, but analysing a business with each method can help owners make the best case for their business. Regardless of which method is used, it is essential to have full financial records, including tax returns, for at least the past five years.