Construction Company Valuation Primer

1 3 JOURNAL OF Construction ACCOUNTING AND TAXATION May/June 2001 What is the fair marketvalue of a constructioncompany in today s mar-ket? The obvious answeris: whatever can beobtained upon sale. However, short ofputting the Company up for sale, there aremethods and techniques to assist anowner in determining a fair market purpose of this article is to providea basic Primer in Construction companyvaluation OF FAIRMARKET VALUEFair market value is defined in IRSR evenue Ruling 59-60 as follows:the price at which property wouldchange hands between a willingbuyer and a willing seller when theformer is not under any compulsionto buy and the latter is not under anycompulsion to sell, both parties hav-ing reasonable knowledge of value of an item tends to be deter-mined by the cost of acquiring an equallydesirable item. A business acquisition isan investment and should be judged assuch. The opportunity cost, or what youcould buy for the money, is what deter-mines VERSUSAPPRAISALT here is a difference between a valuationand an appraisal.

2 Appraisals are often usedas part of a business Valuations: Fundamentals,Techniques & Theory(a training manual ofThe National Association of CertifiedValuation Analysts), the following defini-tions are found: Valuation : To establish a value for anentire or partial interest in a closelyheld business or professional prac-tice, taking into account both quanti-tative tangible and intangible factorsassociated with the specific businessbeing : To establish a value of cer-tain specific tangible assets basedupon special market knowledge,education, and vocational trainingpossessed by the CompanyValuation PrimerFred Shelton, Jr., CPA, MBA, CVAEXECUTIVE SUMMARY This article explores the methods and techniques used in Construction Company Valuation . Using an illustrative Sample contractor, the article tracks the steps involved in the determination of SHELTON, JR.,is Managing Director ofShelton & Company ,CPAs, , an account-ing and consulting firmlocated in CentralVirginia.

3 The practiceconsists almost exclu-sively of audits andreviews of, and consult-ing with, contractorsand their related busi-nesses, including assis-tance with the specialtax and financial prob-lems faced by contrac-tors. Mr. Shelton hastaught courses inaccounting and taxationfor contractors for theVirginia Society ofCertified PublicAccountants, and otherprofessional organiza-tions, and has been afrequent guest speakerand lecturer for varioustrade and businessgroups. For more infor-mation about Shelton & Company , go OF Construction ACCOUNTING AND TAXATION May/June 2001 PURPOSE OF VALUATIONT here are many valid business reasons tohave a Company valued, including mergersand acquisitions, buy/sell agreements,estate planning, ESOPS, purchase priceallocations, litigation, and financing assis-tance. The purpose for which a companyis valued can affect the final outcome. Forinstance, an estate tax Valuation will oftenbe different from the value derived for anactive sale of a thriving OF MERGERS ANDACQUISITIONS ON VALUEThe Construction industry is highly frag-mented, with most companies beingclosely held.

4 It is, therefore, an industryripe for mergers and rollups. It may bemore important now than ever to knowthe fair market value of a of the consolidators have beenpaying multiples of four to six timesEarnings Before Interest and Taxes(EBIT) for specialty contractors. Thistechnique, or rule of thumb, is consideredrisky and may not be indicative of thetrue value of a Company . In reality, a mul-tiple is merely an inverse of a capitaliza-tion rate, which is explained later in with all supply and demand situa-tions, when demand exceeds supply, thecost curve shifts, increasing the price METHODST here are three commonly used methods,or approaches, employed in business valu-ations. Each of these methods and theirvariations are as follows:I. Asset Based Approach1. Adjusted Book Value2. Book Value3. Liquidation ValueII. Income Approach1. Capitalization of Earnings2. Excess Earnings (TreasuryMethod)3. Discounted Future EarningsIII. Market Approach1.

5 Public Company Data Paying Capacityii. Price Earnings Ratiosiii. Price/Earnings Before Interestand Taxesiv. Price to Book Value2. Transaction of Thumbii. Database ComparisonThe above methods are not equal are applied to different companiesin different situations. The valuationmethod chosen by a valuator depends onmany Valuation Methods Commonly UsedOf the three primary methods of businessvaluation (the asset based approach, theincome approach, and the marketapproach), two methods are commonlyused for Construction Company majority of Construction companiesare closely held. Because of this, the infor-mation concerning a sale of an individualbusiness is private and difficult to tends to discourage the use of a mar-ket most Construction Company valua-tions, the Valuation method is essentially achoice between the capitalization of earn-ings, or cash flow, versus an adjusted bookvalue method. An adjusted book value isoften considered to be a floor of to use a particular method is amatter of of Earnings VersusAdjusted Book ValueThe particular industry in which a con-tractor operates often has an effect on thevaluation method may be moreimportant nowthan ever toknow the fairmarket value ofa OF Construction ACCOUNTING AND TAXATION May/June 2001 Highway contractors usually have a sig-nificant investment in fixed assets, specif-ically equipment.

6 Because of the nature ofdepreciation, many highway contractorshave hidden equity in their , fixed assets are fully depreciatedeven though such equipment may havesubstantial value at auction, or can providesecurity for financing purposes. Withproper maintenance, loaders, dozers, andcranes have a tendency to retain valuelong after a normal depreciable life to the latest ConstructionFinancial Manager s Association (CFMA)survey, for most highway contractorsowner s equity will often make up asmuch as 43 percent of the value of addition, the heavy highway markethas been intensely competitive over thepast several years. Profit margins havebeen nominal. According to the 2000 Construction Industry Annual FinancialSurvey, Twelfth Edition,the composite netprofit margin for highway contractors wasonly percent. That is down from theyear before. In 1999, net profit for report-ing companies was of the hidden equity describedabove, most highway contractors have avalue substantially in excess of the oldstandard book value.

7 Highway contractorsalmost always obtain Construction con-tracts by competitive bid, and have littleor no negotiated projects. Because of therequirement to be low bidder, and withlittle assurance of level cash flows, heavycontractors are often poor candidates forcapitalization of contrast, general contractors oftenhave very little heavy equipment. Theyare also often highly leveraged with debtand have relatively low owner s equitycompared to assets. Because of this, thecapitalization of earnings method is oftenemployed in Valuation , as opposed to anadjusted book contractors, like general con-tractors, usually have a much smallerinvestment in equipment. These contrac-tors tend to be labor intensive and relymuch less on equipment. Electrical andHVAC contractors tend to be candidatesfor the capitalized cash flow or RATESThe discount rate applied must be thesame as the rate of return being offered toattract capital in the type of businessbeing valued.

8 It is in fact the cost of capi-tal. It is made up of a safe rate of return( , treasury bills) and a rate of return forthe additional risk associated with two methods most often describedin conjunction with the development of adiscount rate are the build-up method, discussed later in this article, and the useof the Capital Asset Pricing Model(CAPM).The CAPM assumes that expectedreturn is equal to a risk free rate, plus beta,times the expected return, less a risk free major problem with this technique isthat you need to know the return oninvestment. Return on investment is cal-culated based upon the price of the the stock price is available, why is therea need for Valuation calculations?DISCOUNT VERSUSCAPITALIZATION RATESMany use the terms discount rate andcapitalization rate as if they were inter-changeable. They are usually not! JamesR. King, CPA, CVA, in his treatise,Development of Discount/CapitalizationRates (The National Association ofCertified Valuation Analysts, 1998), gives the following definitions:A discount rate is a yield rate used toconvert an anticipated future benefitstream into a present value.

9 The dis-count rate represents the total rate ofreturn the investor expects to realizeon his investment. This is the returnreceived while holding the invest-ment as well as the proceeds on liq-uidation of the discountrate appliedmust be thesame as therate of returnbeing offered toattract capitalin the type ofbusiness OF Construction ACCOUNTING AND TAXATION May/June 2001A capitalization rate is a yield rateused to convert a single benefitstream into present value. The capi-talization rate represents the currentrate of as Dr. Shannon Pratt writes in his1998 book, Cost of Capital Estimation andApplications(John Wiley & Sons, Inc.):Discount rate and capitalization rateare two distinctly different .. discount rate equates to cost ofcapital. It is a rate applied to allexpected incremental returns to con-vert the expected return stream to apresent capitalization rate, however, ismerely a divisor applied to one singleelement of return to estimate a pre-sent capitalization rate is often consideredto be the discount rate less expectedannual the future is unknown, thepast often serves as a surrogate.

10 As such, acapitalization rate is often applied to anadjusted cash flow or DATA FUTUREEARNINGSIt is important to note that in determiningthe value of a business, the potentialbuyer is interested in the future earnings(cash flow) of the business. The IRS, inRevenue Ruling 59-60, specifically recog-nizes that, Valuation of securities is, inessence, a prophecy as to the future. In performing valuations of businesses,and lacking knowledge as to future earn-ings, Valuation analysts use the past as asurrogate for the future. In reviewing his-toric data, most valuators analyze, at mini-mum, the Company s last five years offinancial data. Financial statements areadjusted or normalized to produce eco-nomic financial statements as opposed toGAAP statements. This is done to elimi-nate excessive distributions, salaries, orvarious perks taken by the current ownersthat could distort the true earnings of Morris Associates publishesannual financial statement studies withdata classified by SIC code.