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Key factors to consider when valuing a construction company

Apr 05, 2021

By Brandon Christopherson

When construction companies develop construction project bids, they rely on clearly defined scope documents for estimating costs and schedule. Estimating the value of their own construction company, however, is not always so clear-cut.

Business valuations are often required when it comes time to take a company in a new direction, such as a sale, a merger or a transfer of ownership. But unlike a set of construction drawings, which specify the project parameters, a construction company’s valuation relies, in part, on qualitative versus quantitative factors that aren’t always easily identified. 

For construction companies, cash flow forecasts are dependent on customer demand, economic conditions and competition, which are not always easy to assess as economic conditions can change quickly — such as what happened in 2020 with COVID-19. In addition, construction companies can be very reliant on the owner or a few employees and the value of the company may leave the company with the loss of a key employee. 

For these reasons alone, construction companies are among the most difficult organizations to value. Relying on back-of-the-envelope calculations or an appraiser with limited industry experience could result in significant over- or undervaluation. Before starting this journey, you should first understand the basics of the process and the variables that will influence your company’s value.  

Three approaches to construction company valuations

In general, there are three primary approaches to consider when appraising a construction company’s value.

1. Market-based valuations

This method compares the company’s performance to transaction data available from close peers. For example, an appraiser may analyze performance metrics from similar or comparable construction firms to develop a fair market value estimate. 

The ultimate outcome is to assess the value of a business through the application of several ratios of value to financial metrics or non-financial metrics of reasonably comparable guideline companies. 

This approach may be of limited application if data on comparable transactions is privately held. Multiples are often forward-looking, which can be difficult in construction companies. 

2. Income-based valuations

Income-based valuations use the company’s expected cash flows to determine value. With this method, appraisers can use the discounted cash flow method or the capitalization of earnings method. The cash flow method allows appraisers to estimate future revenue over a set period of time. The capitalization of earnings method uses a single normalized annual cash flow estimate to assume a stable growth rate over time. Normalizing of earnings is a key aspect of this approach and is often misunderstood. Having a reasonable “normalized” earnings is the key to a reasonable valuation.  

An established general contractor with a history of success, a small fixed-asset base and a strong backlog is a good candidate for income-based valuation.

3. Asset-based valuations

The asset-based approach determines a company’s estimated equity value by subtracting liabilities from assets that have been adjusted to market values. Assets include real property, tangible personal property, intangible assets, notes and accounts receivables. An equipment appraisal is typically recommended when using this approach. 

With businesses that are in an industry that are homogeneous, or similar, and where competition is high, the value of goodwill could be limited. Construction companies are very homogenous, and competition can be significant. This indicates a lower value for goodwill, which makes the asset-based approach one of the more reliable approaches for construction companies.

To build goodwill value in a construction company, management would need to create value by developing unique processes or products, good customer retention, a diversified workforce or specialized equipment.

Key variables that drive value

In the construction industry, a thorough appraisal will look at more than just assets and liabilities. Appraisers should also have an understanding of the key variables that drive value, including:

  • Backlog: The goal of any valuation is to get a picture of the future. A company’s backlog is a good metric for gauging future cash flow. In particular, backlog must be accounted for if the appraiser is using an asset-based approach. This is because future profit from these jobs will be considered a company asset.
  • Fixed assets: Fixed assets — including equipment, machinery, buildings and land — must naturally be factored into a valuation. If a company is asset-intensive, debt financing will likely come into play. A qualified equipment appraisal should be folded into the process to determine fair market value based on age and condition. In addition, any leases should be evaluated for projected costs based on the potential for replacement needs.
  • Key relationships: Relationships between company leaders, an established customer base and key project partners can also provide insights into a company’s value. Appraisers are not in the business of analyzing relationships. However, contractual relationships — especially those that create a competitive advantage — should be taken into account when valuing a company.
  • Customer base: The customer base is also an indicator of long-term value. Does the company have a diversified customer base, or does a majority of revenue flow from a few key customers? A concentrated customer base poses more risk, which could affect the value.
  • Economic trends: The construction industry is sensitive to prevailing economic trends. Companies that specialize in a specific product may have greater exposure to loss if demand for that product type falls. For example, as consumers increasingly adopt e-commerce over brick-and-mortar shopping, the demand for retail centers could decline. Likewise, the demand for distribution/fulfillment centers is showing significant growth. 
  • Litigation risk: Litigation is not uncommon in the construction industry. The appraisal will need to factor in liabilities associated with current or anticipated litigation. 

Increasing the value of your company

Construction companies are challenging to value because so much about the future is uncertain. But that’s not to say that owners have no power over their future outlook. To increase cash flow and improve your company’s potential value, you can:

  • Implement cash-conservation strategies
  • Perform long-term cash forecasting and modeling
  • Be diligent about accounts receivable collections
  • Create and implement business processes that improve efficiency and reduce waste
  • Audit labor costs to ensure you are not overpaying unemployment taxes
  • Revisit your go-to-market strategy to ensure you are pursuing projects that will deliver the best return
  • Diversify your client base

How Wipfli can help

Wipfli provides clarity and confidence with business valuations. We offer extensive experience valuing large and small businesses across all segments in the construction industry. In addition, we will help you understand the risks and opportunities that influence the value of your business so you can plan accordingly. Click here to learn more

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