Spring 2007 issue of Horizons

INDUSTRy u

Contractors

VALUING CONTRACTORS In the life cycle of the typical contractor, at some point along the way, the value of the business or an interest in the business will likely become an issue. It may become an issue because the contractor is growing and taking in new shareholders and needs to establish a purchase price for the new shares. Or, it may be due to the acquisition of another company, and the value of the target company must be determined to provide information useful in negotiations. Valuations also are needed when existing shareholders are doing estate planning or considering selling their ownership interests. Whatever the reason, when it becomes an issue, having a solid handle on valuation is critical. Companies in the contracting industry present some unique issues that impact value and must be understood to arrive at a sound value conclusion. There are three basic approaches used in the valuation of any business. Here is a simple explanation of what they are: COST APPROACH The cost approach develops an indication of value for the business by marking up the balance sheet assets to market value. The weakness of this approach is that it typically focuses on tangible assets, ignoring the intangible value of the business. For some contractors, intangible assets such as customer relationships and goodwill are significant. INCOME APPROACH The income approach develops an indication of value for the business by considering the company’s future revenue and earnings potential. This approach can be challenging to apply in the contracting business due to the cyclical nature of the industry. Typically, historical revenue and earnings and current year projections are used as an indication of future levels. These earnings are divided by a capitalization rate, resulting in an indication of value for the business.

MARKET APPROACH The market approach develops an indication of value for the business by looking at comparable company transactions. These transactions provide earnings multiples that are applied to the subject company. Valuing businesses in the contracting industry can be challenging and poses its own specific issues and areas of focus for the valuation analyst. Some of the factors that make contracting businesses unique are: CYCLICALITY Contractors operate in a dynamic industry environment. Construction projects can be very big-ticket items; thus, spending on new construction is very sensitive to cyclical factors such as economic growth, interest rates, etc. Further, sub-sectors within the construction industry can be subject to different trends because they are geographically driven by local market conditions in a given city or region or because they are driven by end user type. These trends must be specifically identified and analyzed as they relate to the company’s historical and future performance. PROJECT CONCENTRATION The typical contractor derives total revenue from a limited number of projects in any given year. This level of concentration means that it is important to understand and analyze all projects, both those in process as well as those completed during the year. Because the value of the business is a function of the future earnings, the challenge is to determine what the ongoing level of gross profit is for the company. To the extent that there are significant client relationships that result in a stream of multiple projects from a given client, it is important to analyze the effect this repeat business has on reducing the degree of earnings volatility over time. In addition, these type of clients may be granting work on a negotiated basis, which may provide more predictable earnings as compared to contracts that are granted on an open-bidding basis. PROJECT DELAYS, CANCELLATIONS Projects can be subject to delays as a result of circumstances beyond the control of the contractor, resulting in projects being shifted into the next fiscal year

17 u summer 2007 issue