Construction Company Valuation Approaches and Methods
By Alina Niculita, ASA, CFA, ARM-BV, MBA
A construction company may need to be valued for various purposes:
- Transactions – business sale or shareholder redemption
- Litigation – ownership disputes or divorce cases
- Compliance – gift and estate tax reporting
- Planning – estate or internal planning
Drawing on several recent engagements in the construction industry, we discuss the three main valuation approaches (income approach, market approach, and asset approach) and methods that are most applicable to construction companies.
1. Income approach
The two main methods under the income approach are the discounted cash flow method and the capitalization method. The discounted cash flow method uses cash flow forecasts for several years into the future to estimate value.
Because of the cyclical nature of the construction industry and the uncertainty regarding obtaining future projects, cash flow forecasts are not likely to be available, especially for small contractors. When the subject of the valuation is a large business with an established track record and forecasts of future cash flows are available, the model may be applied. If the contractor has a backlog of executed contracts, the discounted cash flow method can be used to estimate the value of the backlog.
The capitalization method uses cash flow forecasts for one year into the future to estimate value, and it is typically a better fit for smaller construction businesses. The method is also appropriate for a mature construction company expected to continue to operate similarly to past historic patterns. This method is also used when longer-term forecasts are not available, which is typically the case in the construction industry, as mentioned above. The amount of cash flow that is used in the capitalization method needs to be normalized, i.e. expected to be received by the business under normal business conditions, free of non-recurring or non-operating items. When up and down cycles due to the industry’s cyclicality are apparent in the company’s revenues and profits, the appraiser may consider a long-term average of historical results as a normalized amount to use in the capitalization method. This is especially important to consider when the valuation date happens to coincide with the high or low of the current economic cycle.
2. Market approach
The two main methods under the market approach are the guideline public company method and the transaction method.
The guideline public company method uses the public trading multiples of publicly traded construction companies to estimate value. Most publicly traded construction companies are large, diversified, multi-billion-dollar businesses, and unlikely to be adequately comparable to small construction contractors. As a result, this method is unlikely to be useful to value most privately held construction firms, but a valid method to consider for valuing large private businesses.
The transaction method uses comparable privately held as well as publicly held companies that have been merged or acquired in a change of control transaction to estimate valuation multiples to value the subject business. Generally, this method may be appropriate to value a smaller construction contractor, but it depends on the availability of comparable transactions.
The standard of comparability is that the guideline transacted business is in the same or similar business, but other comparability criteria may apply such as size and profitability. Increasing the difficulty of finding comparable companies to apply the market approach is the fact that there are relatively few publicly traded and merged and acquired construction companies. Market data from 2023 shows that there were only 87 publicly traded construction companies out of 9,720 (representing less than 1%).[1] Similarly, there were 2,370 transactions of construction companies out of 46,949 completed sales of businesses in all industries (representing 5%).[2] Additionally, because of the great diversity in the types of construction performed by different contractors, [3] the business appraiser must strive to choose the most comparable guideline companies from the limited pool of data.
3. Asset approach
The asset approach considers the underlying values of all the assets and liabilities in the business. The difference between the assets and liabilities is the value of the business. Although in theory the approach is applicable to all types of businesses, in practice the asset approach is generally applied for asset-heavy businesses, such as real estate holding companies or heavy manufacturing businesses. The asset approach is also appropriate for situations when the business is valued under the premise of liquidation.
This approach is generally seen as a last resort approach in valuing an operating company such as a construction company using a going concern premise of value. The net asset value method is most commonly used under the asset approach, which would include an evaluation of both tangible and intangible assets.
Some analysts use a variant of this method, the net tangible asset value method, where only tangible assets are evaluated. This method is useful when the engagement also requires a qualification of goodwill in the business and a potential split between personal and business goodwill, such as a valuation for divorce purposes, in states where personal goodwill is not a marital asset [4]. Some assets and liabilities that may need to be analyzed, although not listed on a business’s balance sheet include the backlog of projects and potential contingent liabilities.[5]
Valuation discounts
If the purpose of the valuation is to value a noncontrolling interest in the business, discounts for lack of control and lack of marketability would need to be considered. Even when a controlling interest is evaluated, there are other types of discounts that may need to be considered such as a key person discount. Valuation discounts are an integral step in the valuation process and are often used as an estate tax planning tool.
Conclusion
There are hundreds of thousands of construction companies in the U.S. of numerous specialties and ranging from very small to multi-billion-dollar size that may need valuation for both litigated and non-litigated purposes.
Some methods may be more appropriate than others when valuing construction contractors based on the specific facts and circumstances of each business. In order to choose the appropriate valuation methods, the appraiser needs to understand the industry and the business. See our primer on the construction industry for insights based on recent valuations.
[1] Based on Tagnifi search as of June 2023, and filtered by “Construction” SIC codes. https://tagnifi.com/companies
[2] Based on DealStats search as of June 2023, and filtered by “Construction” SIC codes. https://www.bvresources.com/products/dealstats
[3] Construction Industry Insights Based on Recent Business Valuations, By Alina Niculita, ASA, ARM-BV, CFA, MBA
[4] Valuing goodwill in divorce: State-by-state breakdown of enterprise & professional goodwill jurisprudence. https://www.bvresources.com/blogs/business-valuation-law-news/2019/04/05/valuing-goodwill-in-divorce-state-by-state-breakdown-of-enterprise-professional-goodwill-jurisprudence
[5] Construction Industry Insights Based on Recent Business Valuations, By Alina Niculita, ASA, ARM-BV, CFA, MBA
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Alina Niculita is a valuation and testifying expert who has specialized in business appraisal and appraisal review for litigation cases and business transactions for two decades. She has appraised hundreds of companies in diverse industries and sizes up to several billion dollars in revenue and testified in support of her opinions.
503-906-1585 | [email protected]
