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Business Valuations

Most contractors are missing a critical piece of information – the value of their company. This information is necessary to reach the right conclusion when planning your future. Without a firm understanding of the value of your business it will only be by accident that you arrive at the right answer to questions like: Do I have enough to retire? Should I sell the business? Am I better off pursuing a lawsuit or cutting my losses? A valuation can also be used for other purposes, such as for gift tax and buy-sell agreements.   

Although some owners think they know the value of their business, few do. Unless you undertake a valuation of your company, you can’t be certain of its value. That can lead to some expensive mistakes.

What Drives Value?
Other than the psychological satisfaction of being the owner – getting in before everyone else, worrying about whether you will be able to renew your bonding, losing sleep over whether your bid won because you made a mistake – the only reason to own a business is the cash flow it can produce. The value of a business is a function of its expected cash flows, the timing of those cash flows and the riskiness of those cash flows.    

Business valuators generally consider three approaches when valuing a business: the income approach, the market approach and the asset approach.  

Income Approach
Under the income approach, the valuator estimates the expected cash flows to the business and then applies an interest rate to calculate the present value of those cash flows. The interest rate used should reflect the timing of the cash flows as well as the riskiness of those cash flows relative to other investments.   

Estimating cash flows for contractors can be difficult in that future work is often subject to bid. For a contractor with a long history and who does many small projects, this is less of an issue than for a contractor who only does a small handful of relatively large jobs or who does only sealed-bid jobs.  

Market Approach
In utilizing a market approach, the business valuator identifies private companies that have engaged in a transaction or comparable publicly traded companies. The valuator then utilizes these comparable companies or transactions to derive multiples, which are applied to the subject company. For example, the valuator might calculate a multiple of revenue or earnings before interest, taxes, depreciation and amortization (EBITDA) for the comparable companies and apply those multiples to the company.   

One difficulty in applying the market approach is finding comparable companies. For large general contractors, the valuator might be able to locate publicly traded comparable companies, but may have trouble doing so for smaller companies and specialty contractors. Even for larger companies, the valuator should be certain that the companies are truly comparable.     

For example, adjustments might need to be made in comparing a large, private general contractor to a public general contractor who also offers other services such as design, engineering and architecture.  Public companies might also be specialized in a particular industry, such as road building or public works.   

The business valuator also faces difficulty in applying private company transaction multiples to the subject company. Depending on the company, the valuator might not be able to find comparable companies that have recently engaged in a transaction. It can also be difficult to get adequate information regarding a private transaction to generate a multiple. For example, the purchase price might have been paid in cash or a combination of cash and some future consideration. Also, the EBITDA might or might not be adjusted to account for owner perks.

Asset Approach
When utilizing an asset approach, the value of all assets – both tangible and intangible – is calculated.  The sum of the individual asset values represents the total asset value of the enterprise. This approach is frequently used in valuing investment holding companies or operating companies when the value of the underlying assets exceeds the value of the operations.  

Common Mistakes
In attempting to determine what their business is worth, business owners often make a few common errors. One  is relying on the value of the assets as shown on their balance sheet. These values often do not represent current market value. For example, fixed assets are recorded at their cost and then depreciated. A piece of earthmoving equipment purchased five years ago might be fully depreciated.  However, the market value is not necessarily zero.  Other assets, such as the value of the goodwill in the business, are often not recorded on the balance sheet at all.   

Another common error is relying on rules of thumb.  As previously discussed, businesses are often valued on multiples, such as revenue multiples and EBITDA multiples. For example, a contractor might be sold for the underlying asset value, plus a multiple of the backlog.  However, blindly relying on this rule of thumb might cause you to misstate value unless a thorough analysis is performed.  Without a thorough analysis, the owner might not realize the value inherent in individual contracts, such as contracts that have a higher than average profit margin.   

Knowing the value of your business is an important piece of information for decision making. For the information to be useful, you must be confident that you truly do understand the value of your business.

This publication is part of Blackman Kallick’s marketing of professional services, and is not written tax advice directed at the specific facts and circumstances of any person and/or entity. Contents of this publication are of a general nature, and you should not act on this information without obtaining professional advice from your business advisor that is appropriately tailored to your individual needs and circumstances. This written advice is not intended or written to be used, and cannot be used by any taxpayer, for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code.