Know your worth
Valuation insights can be priceless

Often, a construction company owner has an amount in his or her head representing the presumed value of the business. The contractor may keep this amount “on file” in case he or she should ever decide to sell the company. Problem is, the number may vary drastically from what the market will pay.

The only way to know for sure is to obtain a professional business valuation. And selling your business isn’t the only reason to do so. Valuations also can help determine how much you can borrow, whether it’s a good time to aggressively grow your business, and if you might need to update your estate plan. In short, valuation insights can be priceless.

One starting point

Valuation is a specific service that your CPA may offer or, if not, he or she can refer you to a qualified expert who specializes in the construction industry. (Your CPA may remain involved to help facilitate the process.) It’s critical to work with experienced experts because they can determine whether certain “rule of thumb” approaches to valuation are applicable or whether some other method is more appropriate.

A starting point for some valuations is with a construction company’s previous five years of tax returns or financial statements. Some appraisers may use these to project a growth rate for sales revenue. This can be represented by the formula:

((Previous year’s gross sales revenue / gross sales from five years ago) ^ 0.25) – 1

Once the company’s growth rate is calculated, an appraiser may project cash flows for five years into the future so that those cumulative cash flows can be brought back into today’s dollars to estimate the net present value of the business.

To project cash flows five years into the future, the appraiser will estimate the rate of inflation (perhaps at 2%) and calculate the company’s tax rate. If the tax rate is uncertain, he or she may approximate the rate using a percentage (such as 25% or 30%). The appraiser can then chart projected sales revenues, net of tax and adjusted for inflation, for the next five years.

Cost considerations

An appraiser may forecast and deduct costs from these sales revenue projections. To do so, he or she will identify variable costs and fixed costs using a construction company’s financial statements or tax returns. Generally, cost of goods sold (cost of sales) accounts are considered variable costs, while operating expenses are considered fixed costs.

The appraiser may calculate variable costs as a percentage of sales and then project these costs for the next five years. Fixed costs are typically held constant with a factor added for inflation. To arrive at the resultant operating cash flows, the appraiser will likely deduct variable costs and fixed expenses from the next five years of accumulated sales figures, net of tax.

Depreciation and working capital

Depreciation has a distinct cash flow advantage that arises from tax savings. An appraiser can calculate the depreciation cash flows attributable to tax savings by multiplying the most recent previous year’s depreciation expenses by the company’s anticipated tax rate. He or she will likely then add the resulting value to each year for the next five as a cash inflow without adjusting for inflation.

An appraiser may also project working capital changes and fixed asset repairs and maintenance for the next five years, similarly based on historical data. Working capital changes primarily arise from changes in year-end accounts payable and receivable. If a construction company has been trending a certain way for the five years leading up to the valuation date, an appraiser may account for this when projecting cash flows.

Total cash flows

In this manner, an appraiser can calculate the total net resultant cash flows, both for each of the next five years and accumulated as a grand total of five years in the future.

What’s more, the appraiser can tally up a construction company’s fixed assets (such as vehicles, equipment, buildings and machinery) as of the valuation date at their current fair market values. He or she can then calculate that fixed asset value for five years into the future without adding in any new assets or taking away any existing ones.

Once this is done, an appraiser may choose a discount factor equivalent to the rate at which the company is currently borrowing — perhaps around 8%. Using this factor, he or she can discount each of the next five years’ cash flows using present value formulas. The sum of those five years’ worth of net cumulative cash flows discounted to today’s dollars will estimate the company’s value as of the valuation date.

One approach among many

The valuation method discussed here is just one possible approach among many. For example, another effective way to gain insight into the value of a construction company is to get current transaction and market data from an M&A firm that specializes in the industry.

The ideal approach for your business will depend on its size, structure and history, as well as your objectives for getting the valuation in the first place. Nonetheless, we hope this provides some perspective on just how informative a business valuation can be. •