When a business valuation is needed, many contractors want a
quick answer. That's understandable. But an overly simplistic approach can
create a false sense of certainty — especially in an industry where leadership
ability, financial performance and operational risk can vary widely from one
company to another. The next time your business needs a valuation, beware of
rules of thumb.
Tempting shortcuts
Simple valuation formulas are typically based on industry
averages and passed along by word of mouth. For example, to do a "DIY" business
valuation, some contractors may use a multiple of earnings before interest,
taxes, depreciation and amortization (EBITDA) or a percentage of annual revenue
plus inventory and tools. Other rules of thumb are based on actual sales
transactions in the construction industry.
Whatever form they may take, the problem is the same: Basic
calculations don't account for all
the elements that drive a construction business's value. These include factors
such as:
- Management
expertise,
- Workforce
stability,
- Backlog
quality,
- Contract type,
- Bonding
capacity,
- Growth
potential,
- Cost
structure, and
- Reputation.
Many of these elements are qualitative and hard to capture with
a single financial metric. In addition, rules of thumb can become outdated as
market conditions change and vary by geographic location or specialty. As a
result, applying a rule of thumb may under- or overvalue your company.
An example to consider
Let's say Construction Company A and Construction
Company B each have EBITDA of $1.5 million. According to one
valuation rule of thumb sometimes used in the construction industry, each
business is worth three times EBITDA, or $4.5 million.
The two businesses are nearly identical in most respects, with
one critical difference: Company A derives 70% of its revenue from three
local developers, while Company B doesn't rely on any one project owner
for more than 5% of its revenues. Given Company A's higher level of risk,
Company B is likely worth more, even though the formula values them
equally.
There are many other factors that affect value but aren't
reflected in this rule of thumb. Perhaps one business has stopped investing in
equipment maintenance, workforce development or other upgrades needed to
sustain future earnings — temporarily inflating EBITDA but placing the
company's future earnings at risk. That lowers its value to a prospective
buyer. Or maybe the other business has done a better job of controlling costs,
making it more profitable. That raises its value.
Important decisions
Whether you're looking into a business sale, developing a
succession plan or plotting strategic growth, a professional valuation can
provide a clearer picture of what your construction company is really worth.
So, don't hesitate to consider one when the time is right.
Just watch out for those rules of thumb. Although they can offer
a rough starting point, overly simplistic methods shouldn't drive important
decisions. We'd be happy to support your business throughout the valuation
process.
