Construction leaders know how to develop solid budgets and schedules for complex building projects. But estimating the value of their companies? That’s not always as easy.
Business valuations are often required before a sale, merger or transfer of ownership. Before leaders pursue a new strategic direction, they need a strong sense of the business’s worth. But unlike a set of construction drawings (which specify project parameters like scope and material costs), a construction company’s valuation is more nuanced.
For one thing, cash flow forecasts can be complicated. Many construction companies use percentage of completion to track their financial performance. And intangible values, such as personnel, relationships and reputation, also need to be factored in.
Construction companies are among the most difficult organizations to value. Without deep industry experience, you could receive a significant over- or undervaluation — which could compromise future strategies. Make sure you understand the valuation process for the construction industry, as well as variables that influence your company’s value.
How much is your construction company worth?
There are three approaches that work best for appraising a construction company’s value: the market-based, income-based and asset-based approaches.
1. Market-based valuation
The market-based valuation method compares your company’s performance against transaction data 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 appraiser should apply several ratios of value to financial metrics or nonfinancial metrics. This approach may have limitation if data on peers or comparable transactions aren’t available (e.g., if they are privately held).
2. Income-based valuations
Income-based valuations use the company’s expected cash flows to determine value. 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. The capitalization of earnings method uses a single normalized annual cash flow estimate to assume a stable growth rate over time. Income-based valuation works well for construction companies with an established history of success, small fixed-asset bases and strong backlog.
3. Asset-based valuations
The asset-based approach determines a company’s estimated equity value by subtracting its liabilities from its assets. Assets include real property, tangible personal property, intangible assets, notes and accounts receivables.
The asset-based approach is best suited for companies that have large investments in fixed assets, such as heavy machinery and equipment.
Variables that drive value in construction companies
In the construction industry, a thorough appraisal should look at more than just assets and liabilities. Appraisers should also understand key variables that drive value in construction firms, including:
- Backlog: The goal of valuation is to get a picture of the future. A company’s backlog is a good metric for gauging future cash flow. Backlog must be accounted for if the appraiser is using an asset-based approach because future profit is considered a company asset.
- Fixed assets: Equipment, machinery, buildings, land and other fixed assets must be factored into 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, leases should be evaluated for projected costs based on the potential for replacement needs.
- Key relationships: Relationships between company leaders, customers and key project partners can also provide insight 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 considered during valuation.
- Customer base: Your customer base is another indicator of long-term value. Does the company have a diversified customer base, or does most revenue flow from a few key customers? A concentrated customer base poses more risk, which could affect value.
- Economic trends: The construction industry is sensitive to prevailing economic trends. Companies that are specialized or serve a niche need may have greater exposure or opportunity. For example, as consumers 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 common in the construction industry. An appraisal needs to factor in liabilities associated with current or anticipated litigation.
How to increase the value of your construction company
Construction companies are challenging to value, in part, because the future is so uncertain. But that doesn’t mean owners are powerless. Construction owners can take specific actions to increase the value of their companies.
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 focus on projects that deliver the best returns.
- Diversify your client base.
How Wipfli can help
Wipfli provides clarity and confidence in business valuations, even in complex companies and industries. We offer extensive experience valuing large and small businesses across all segments of the construction industry. We can help you understand the risks and opportunities that influence the value of your business so you can plan accordingly. Contact us or keep reading:
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