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FMI Quarterly/December 2015/December 1, 2015

The Capitalization of Earnings Method for Construction Firms

ThinkstockPhotos-531013089-445x298Leverage the right metrics to better support and justify your company’s value.

Construction firm owners are no different from any other business owner when it comes to wanting to know their business’s value. Because there are many reasons why a formal business valuation might be needed — from contemplating a sale of the business to establishing a value for gift and estate taxes — understanding of the value of your business is critical. In this article, we’ll discuss one of the most common methods for determining value and discuss some of the financial and nonfinancial factors that have real and measurable impacts on the value of your business.

But first, let’s get a few terms straight. The first term is market value. Think of market value as analogous to the quoted price of a share of publicly traded stock. It is a value that represents the price at which two unrelated parties would be willing to exchange a good. In our analogy, the market value of a share of publicly traded stock is the last price at which a transaction involving that stock took place. The second term is enterprise value, or the market value of a company’s equity and debt less the company’s cash. It is important to be mindful of these terms as we discuss business valuation because there is often a difference between enterprise value and the value that an owner would receive when selling his or her ownership interest.

It’s All Relative

C.S. Lewis once said, “The architects tell us that nothing is great or small save by position.” I don’t think Lewis was talking about business valuation or even about our kind of architects when he said this, but he makes an important point. What better way to find the value of a thing than to compare and contrast it with the value of another similar thing? To that end, we have what is known as the Capitalization of Earnings Method of valuation. The basic mechanics of the capitalization of earnings method are very simple:

1) Determine a financial metric, 2) Determine a suitable market- based multiple, 3) Multiply the metric and multiple together, and 4) Give yourself a high-five for valuing your business in less than 10 seconds. Sounds simple enough, right? Well, if it really were that simple, I probably wouldn’t need to write an entire article about it (you can still give yourself a high-five for making it this far though).

The first step in the Capitalization of Earnings Method is to determine an appropriate financial metric to use. The most common metrics are revenue or sales, operating income and a frightfully named abstraction known as EBITDA which stands for earnings before interest, taxes, depreciation and amortization. More simply, EBITDA is used as a proxy for your business’s cash flow generation. Just how asset-intensive your business is generally determines which of these financial metrics is the most meaningful for valuation purposes. Of course, no business valuation would be complete without a good, long discussion about what actually constitutes operating earnings or EBITDA. Believe it or not, there are almost as many answers to this question as there are people discussing the matter.

Once you have your financial metric, it’s time to determine a suitable market-based multiple. Depending on the purpose of your business valuation, there are a few different sources of market data from which to derive a suitable multiple. The two sources of market data that are widely available are public company financial data and public transaction data. In either case, the end goal is to isolate a list of public companies or transactions that are similar to yours from an operational, geographic, business risk and size perspective.

Using publicly available valuation figures and financial metrics (generally from public filing documents, press releases and public markets data), we can derive a multiple for each public company or transaction which represents a ratio of enterprise value (remember what this means?) to financial metric. From the range of multiples we’ve derived, select an average or median multiple and then make adjustments based on company-specific operational or market factors (we’ll discuss a few of these below). Once you’ve selected the multiple, you can calculate enterprise value using a simple multiplication. Now, give yourself another high-five! Isn’t valuation fun?

Giveth and Taketh Away
Arguably, the most difficult part of this valuation exercise is the selection, adjustment — and most importantly — justification of the suitable market multiple to apply to your company’s financial metric. In many instances, there is a counterparty (i.e., a potential buyer or seller, the IRS or an attorney) involved in your company valuation. These counterparties will expect you to logically justify and support your valuation analysis. From the explanation in the previous section, the process is speciously simple. However, a great deal of consideration and thought should be given to each adjustment that you make regarding the selected market multiple. Generally, adjustments are made based on a combination of financial and nonfinancial factors in the form of value adders and detractors. We’ll discuss these from a high level so that you can consider how your own business factors might impact value.

Even though the Capitalization of Earnings Method only uses a single financial metric to determine enterprise value, there are financial considerations present in a business that can be used to justify a higher or lower market multiple. They are:

Value Adders

  • Financial — The two most common financial value adders are relative profitability and growth. Depending on how your company’s profitability and growth compare to the average profitability and growth of other similar companies, upward adjustments to the market multiple can be applied.
  • Nonfinancial — For companies in the construction industry, there are several factors which can be used to justify an upward adjustment in the market multiple. Self-perform capabilities, project size capabilities, project pipeline, backlog, flexibility (ability to travel), special relationships with suppliers or customers, integration across multiple disciplines (if appli-cable) and the depth of company management could all support a higher company valuation.

Value Detractors

  • Financial — Excessive use of financial leverage (i.e., high relative debt levels), excessive use of operating leverage (i.e., inefficient capital program), and below-average margin or growth figures can all contribute to a downward adjustment to the market multiple.
  • Nonfinancial — For companies in the construction industry, there are several factors which can be used to justify a downward adjustment in the market multiple. These factors include concentration of risk in certain key segments, customers or geographies, backlog and lack of integration or capabilities compared to peer companies. A significant value detractor can also come in the form of a lack of organizational depth. With closely held private companies, there can often be a tendency to fail in developing a successor management team with the knowledge and experience to grow the business once the founder or longtime owner decides to retire.

If you were paying attention, you might have noticed that backlog was listed as both a value adder and a value detractor (and, no, that was not an error on my part). Backlog is an interesting factor that can be both helpful and harmful. On a positive side, backlog represents revenue that your business will likely earn. On the negative side, the terms of the contract that gave rise to that backlog are set, and profitability depends on efficient project completion. The nature of backlog is different for each company, so it’s important to consider which specific projects are in backlog to determine how they impact value.

I Was Told There Would Be No Math
As an example of the Capitalization of Earnings Method we’ve been discussing, consider the following. We are engaged to value a privately held industrial contractor called Best Construction, Inc., which reported 2014 EBITDA of $500. Based on a company search, we identify three public companies that perform that same mix of work and operate in the same geographic region as Best. Using public filing data, we derive 2014 EBITDA multiples for each of those companies as shown below:

CapitalizationEX1_3

For our valuation, we select the average multiple of 5.6x as a starting place. We then consider the financial and operation characteristics of Best Construction. Based on our assessment of some of the value adders and detractors, we make the adjustments as shown in Exhibit 2 to arrive at our market multiple.

Lastly, we multiply our suitable market multiple by Best Construction’s financial metric to arrive at an estimate of Enterprise Value.

Of course, this is a simplified example, and considerably more analysis can be performed to support the selected public companies and the adjustments made to the market multiple.

More Art than Science
At the end of the day, business valuation is more an art than a science. However, if you have some familiarity with the “science” aspect discussed in this article, you will be better prepared to support and justify your company’s maximum value.


Joe Kaessner is an associate with FMI Capital Advisors, Inc., FMI Corporation’s registered Investment Banking subsidiary. He can be reached at 713.936.5018 or via email at jkaessner@fminet.com.

 

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