Two Methods for Valuing Your Construction Company

September 21, 2018

“What’s the market value of my company?” is a question business owners often wonder about. However, coming up with an answer is far from easy.

To help you make a ballpark estimate of your company’s value, here are instructions any contractor can use. We’ll address two commonly used valuation methods: capitalization of earnings and adjusted book value. Both have many variations that use essentially the same concepts.

Before you start, recognize the following: Valuations involve judgments that, in many cases, you personally won’t have the experience to apply. A formal valuation will also include many steps and concepts that are partially, or not at all, covered below. In addition, your company may involve facts or circumstances that could significantly change the results of a simplified worksheet.

Scrutinizing assets

Valuing your company may involve taking the value of “hard” assets or the company’s future earnings potential and adjusting them based on factors such as the asset replacement values and the value of intangible assets, including goodwill, work in progress or a well-trained employee workforce.

The adjustments may also consider what it would cost to start a construction company that duplicates your operation.

Capitalization of earnings method

The earnings method has variations that can include weighted or unweighted historical earnings or discounted future earnings.

One of the most common methods is the weighted average historical earnings method. This method is preferred by many professionals because it uses the actual historical “adjusted” earnings rather than projected future earnings. It also uses data from a number of years rather than just one that can be unduly influenced by fluctuations in earnings.

The first step is arriving at annual net earnings for the five most recent years. Increase or decrease your net income for items as income taxes, owners’ salaries in excess of market value, non-recurring income or expenses, or any income or expense items that a purchaser would not expect to receive or pay. These adjustments include expenses such as life insurance premiums that are associated with an owner, or income from affiliates. Adjusted earnings are then weighted on a scale from 1 to 5 with the most recent year receiving the highest weighting. The total is then averaged. The weighted average earnings are then multiplied by a capitalization rate or price/earnings (P/E) ratio.

Let’s assume this factor will be based on the cost of funds, or interest rate, the purchaser would have to use if the purchase price was fixed. The degree of risk associated with the construction business should also be taken into account.

Below is a detailed example of the capitalization of earnings method:

Adjusted book value

The adjusted book value method considers the value of each component of the balance sheet for a typical contractor. The adjustments for tangible assets are based on determinable market values, such as appraisals for equipment, land and buildings. Likewise, long-term loans are taken at fair market value. Adjustments for tangible assets are generally easier than for intangible assets. Our advice is to use conservative estimates when adjusting the value of intangible assets.

The value of intangibles is affected by the ability of the existing management to run the organization without the owner being present, the level of training and loyalty of your work force, the amount of business generated from recurring customers vs. competitive bids, and the startup costs.

Judgment call

Before you accept a statement of value based on any method, use your judgment to determine if the approach is reasonable for your individual circumstances. For instance, if two determinations of value for the same business are very different, such as the adjusted book value being two or three times greater than the capitalization of earnings value, consider whether one or more of the following factors distorts one of the valuation methods’ results: