Fall 2014 issue of Horizons

CONSTRUCTION

may be more relevant, particularly if the subcontractor in question does not have a history or expectation of consistent profitability.

There are several reasons for this difference and the key ones are as follows:

∙ Architectural and engineering firms tend to have more diversification among projects in a given year, and as a result, individual projects make up a smaller percentage of their total revenue versus general contractors and subcontractors. As a result, A&E firms generally have less volatile revenue and earnings, and reduced volatility means that a potential buyer will be more comfortable paying a higher multiple for the underlying cash flow stream, as the buyer understands that his downside is more limited than with a more volatile business. ∙ General contractors and subcontractors also tend to have more competition than A&E firms, and competition tends to drive down excess profits and reduce the value of intangible assets such as brand names. Understanding this, a potential buyer will be more willing to pay a higher multiple for a business with a strong brand name in an industry with less competition. ∙ In general, there is also greater litigation risk for general and subcontractor firms versus A&E firms, and the higher risk leads to lower transaction multiples as well. Asset Approach The asset approach as described on page 17 is usually not very applicable in the construction industry. This is particularly true for general contractors and A&E firms that have little tangible value outside of net working capital. In fact, for profitable general contractors or A&E firms, the asset approach should only be used as a reasonableness check, or minimum, that the resultant value from an income approach or market approach should not go below.

Factors That Can Increase Value In addition to the factors described on page 18, which can be applied to all companies,

the following factors are specific to construction-related companies:

∙ Backlog – As the lead times on projects can be fairly significant for construction-related companies, backlog is an important factor to consider in construction-related company valuation. A higher backlog will potentially increase the long-term growth rate used in the income capitalization approach or increase the revenue or EBITDA multiple applied—either of which will increase the resulting value. ∙ Brand strength/reputation – A potential buyer will be willing to pay more for a construction- related company with a long track record of, and reputation for, quality work in its respective market. This is particularly true if the buyer plans to continue to operate under the traditional brand name. ∙ Diversification – Diversification among geographies served or industry focus can serve to reduce the volatility of a construction-related company’s earnings, and, therefore, increase value. ∙ Specialty focus – This somewhat contradicts the previous point on diversification. However, if a construction- related company has significant experience and a strong brand in a niche area, that can lead to above-industry- average profits on projects in that niche, and potentially, a higher valuation. There is risk of being too specialized in one area, which leads to reduced diversification and higher volatility, but if a construction-related company can specialize in several uncorrelated niches,

it can earn excess profits, maintain diversification, and increase value.

For certain types of subcontractors that are more equipment-intensive, the asset approach

page 36 | horizons Fall 2014