October 2002
By JAMES S. ANCHIN, CPA
"How much is my company worth?" is a question construction company owners have probably asked themselves many times. The reasons that prompt this query, to a large extent, determine its answer. But when all is said and done, valuation of a company is heavily subjective; different appraisers can come up with different answers.
If you are considering selling, you will need a valuation placed on your company. Selling stock to employees or to outside investors; litigation over divorce or contract suits; preparation for buying out a partner or partners or simply planning for the future are other valid reasons to initiate the valuation process. Beyond that, the IRS will require those firms with an Employee Stock Ownership Plan (ESOP) to provide a valuation before the plan is established and annually after that.
There are a number of factors that should be considered in putting a dollar amount on a closely held firm. When it comes to a valuation for tax purposes, the IRS weighs in with specifics about what should be entertained. The IRS eschews a simplistic "one-size-fits-all" formula, and the investment and financial communities generally embrace its approach. The IRS stipulates that a number of factors should be taken into account in order to form a composite from which a fair market valuation can be drawn. Several factors have to do with the company itself: its type of business and history, its earnings and dividend-paying capability, its financial condition and book value of the stock, and whether there is "intangible" value. Other considerations pertain to the industry of the company Ñ both the industry outlook and the stock price of similar companies within the industry Ñ and to the economic forecast in general.
Appraisers employ a variety of methods to determine fair market value of a company. Both earnings-based and asset-based methods can be used. With an earnings-based approach, the appraiser begins by determining a proper price-to-earnings ratio, or PE ratio. Generally, a PE for a privately held company is extrapolated from an average of the PEs of publicly held companies. In the construction industry, this may seem to be unrealistic, given the vast differences in revenues, financial resources and subsidiary operations between public and private companies. However, PEs of public companies, adjusted for the differences, can be used to establish a reasonable PE for a small contractor or other privately held construction firm. Appraisers will look at a number of public companies that represent the most similar PEs, factoring in the necessary adjustments, and disregarding those PEs that are either too high or too low, based on non-recurring or extenuating circumstances. A relatively low PE is typical: buyers generally acquire construction companies with PEs between 5/1 and 8/1.
The PE ratio is then put to work with several valuation methods to yield a dollar amount on the company's worth. Valuation methods track earnings over the past five years Ñ either by a simple average or by an average that is weighted toward the most recent year's earnings. Other methods look at only the most recent year's earnings, or at future earnings projected by management.
Another methodology to define the company's worth is based on its liquidation value, or what the company could expect to realize if it were to sell off all of its assets.
Either of these methods will result in different prices an owner can expect to receive for the company. The liquidation method is not considered a good indicator, since the costs to sell or phase out the assets may be substantial. In the earnings-based methods, using only the most recent year as a basis for valuation can generate an unreliable price picture, particularly if it was an inordinately poor or good year. A valuation of the company based on future earnings should be taken with a large grain of salt. Granted, a prospective buyer is most interested in the company's ability to generate future earnings, but that number is only an estimate. Average earnings over time represent the best estimate of future performance and offer the best approach to calculating a price for the company.
In the end, the valuation process can be highly subjective. Ultimately the value arrived is only an opinion, but it will be an expert opinion based on a sound understanding of the company, the construction industry and the economy in general.
About the author: Mr. Anchin is a managing partner of Anchin, Block & Anchin, LLP, a regional certified public accounting firm with offices in New York City and Westchester, that specializes in meeting the needs of contractors in the tri-state area.