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Determining the value of your construction company

INSIGHT ARTICLE  | 

Construction company owners may need a business valuation for a variety of reasons, a possible transaction being the most common. Others include gifting of stock, starting or continuing an employee stock ownership plan, funding phantom stock plans, issuing options to management and transferring other ownership interests. While each of these situations is unique, a proper business valuation is an important part of each.

Determining the appropriate value of a construction business is not an exact science and can be difficult. Often, company owners feel a connection to the business beyond its monetary returns, having grown it from nothing or operating it over a long period. Accordingly, owners commonly benefit from the services of an independent appraiser since their disconnection from the business enhances objectivity and eliminates both actual and perceived conflicts of interest.

Approaches to valuation

There are different standards of value that can be assigned to a company:

  • Liquidation value: the price at which the assets of the business would sell at if an orderly liquidation or fire sale were to occur
  • Fair market value: the price that a business would transact at given a willing buyer and willing seller
  • Fair value: the price at which the business would transact at between hypothetical market participants
  • Investment value: the value assigned by a particular investor, which is not necessarily what others in the market would pay for the company, but what a single investor perceives the value to be

The requirements of the valuation will dictate the standard of value. For example, tax reporting is typically performed under a fair market value standard whereas financial reporting is often performed on a fair value basis.

Traditionally, there are three primary approaches that appraisers consider when valuing a business:

1. Income-based

An income-based valuation relies upon a company’s expected cash flows in assessing value. This method is often applicable for contractors with a small fixed asset base, but a strong reputation or history of success.  Income-based approaches include the discounted cash flow method and the capitalization of earnings method. The discounted cash flow method uses forecasted income statements, working capital and fixed assets for some discrete future period. The appraiser then refines the forecast so that future cash flows more reasonably represent what a prospective buyer may realize. As the next step, the appraiser reduces the future cash flow amounts to a present value amount using a rate of return commensurate with the perceived riskiness of the company’s future cash flows. The higher the perceived risk, the lower the company’s present value. As an alternate method, the capitalization of earnings relies on a singular normalized annual cash flow estimate, based on the assumption the company grows at a stable rate over time. Clearly, the capitalization of earnings method is the simpler of the two methods because it only requires one cash flow estimate. However, it may not always be applicable because a company’s expected cash flows may substantially change.

2. Market-based

A market-based valuation infers company value using data from known transactions of either its private or publicly traded peers. For example, price to earning indices are a common metric by which appraisers estimate a company’s value after comparing its performance to that of its peers. The appraiser often makes additional adjustments to the metrics to account for differences between the subject company’s operations and the peer group.

3. Asset-based

An asset-based approach relies on an assessment of the necessary costs to recreate, reassemble, redevelop, and/or redeploy all of the company’s assets using date-specific prices. A company’s estimated equity value is the total assessed asset costs minus its liabilities. Appraisers typically use this method to value holding companies or companies whose assets are worth more separately than combined (i.e., the company consistently struggles to yield positive cash flows).

Additional considerations regarding the construction industry

There a unique and complex set of considerations required in appraising a construction company. Reasonably reliable company cash flow forecasts are central to any meaningful income-based valuation results. Developing reliable forecasts difficult, but not impossible, given the wide array of industry factors (such as lending rates, consumer and producer confidence, labor rates, material prices) that can change seemingly overnight. Further, a construction company’s value beyond its tangible asset value—its machinery, equipment and real estate—is directly dependent on its ability to create persistent and meaningful cash flows. This ability is often tied directly to a construction company’s reputation for service, finish quality, on-time delivery and worker-friendly policies. This could mean focusing all of the company’s energies on a particular strategy or niche market that may result in above average profit margins. Clearly, there are a variety of ways a construction company can maximize its marketplace reputation, and regardless of the method(s) chosen, sound management is the key to making that happen.

Impact of Tax Cuts and Jobs Act

On Dec. 22, 2017, the president signed the Tax Cuts and Jobs Act (TCJA) into law. The primary changes brought about by the TCJA that affect valuations are reduced corporate tax rates, limitations on the deductibility of interest expense, limitations on net operating losses and accelerated depreciation. The implications vary for each of the different valuation approaches.

Due to the short- and medium-term application of the act, there are significant changes to the forecasted cash flows and expected rates of return. The TCJA will also affect the metrics used in the market approach, as lower tax rates have bolstered market values of many companies. Ultimately, it is important to look at the guidelines closely before making a conclusive decision regarding what metric to use in the valuation.

The TCJA has several components beyond a lower corporate tax rate, such as net operating losses deduction and repatriation liabilities, that will affect a company’s final value. The impact of the TCJA will vary by industry and company; therefore, business owners’ best response is to have a conversation with their tax advisor to closely assess how the TCJA can help or hurt their company’s valuation.

The construction industry is a competitive and challenging market. While the valuation of a company is ultimately the financial value a buyer and seller can agree upon, there is much within the control of the business owner that can be done to positively—or negatively—affect the company’s value.

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