Most construction companies own significant assets such as heavy machinery, vehicles, real estate and miscellaneous equipment. Yet time and time again, these assets are marginalized – or even ignored – when it comes time to value that business. What is the reason this occurs?
An example may help illustrate the issue. Many of our readers own rental properties, and if you ask them, they will probably tell you that a major reason for the investment was the opportunity to generate some extra cash flow over time. Of course, an investment’s ability to generate cash flow is a key component in determining its value. For the rental property owner, however, an owner may also derive value from the property based on the price that a buyer would pay to acquire the property (as opposed to its stream of expected future cash flows). In lieu of projected cash flows, factors such as location, property condition, economic conditions, and even mortgage rates can dramatically impact the property’s actual value. These metrics (cash flow and asset value) can drive meaningful yet divergent values of the property.
In a situation where the value of the cash flows far exceeds the expected sales price of the asset, the owner of the property (and any potential buyer of that property) would most likely focus on the property’s ability to generate cash flows as opposed to the asset value. The opposite should also hold true. Therefore, the dismissal of the asset value in favor of the value indicated by an income-approach may explain why your construction company valuation may appear to “forget” the assets. The issue is, if the value of the business under the asset-based approach is higher than the income-based value, yet the asset-based value is dismissed, the company may wind up being undervalued.
When applying an asset-based approach to valuing a construction business (such as the adjusted net asset method), the valuator computes the net value of all assets less all liabilities of the company. These assets may be tangible (e.g., machinery, equipment, receivables, work in progress) or intangible (e.g., customer relationships, project backlog, name recognition, subcontractor/vendor relationships). Tangible assets like machinery and equipment, which the company may have accumulated over many years, must be considered through the prism of “fair market value” (as opposed to depreciated levels as reported on the company’s books). In order to adjust these assets from book value to fair market value, appraisals of individual assets may be appropriate, which can add cost to the valuation project.
What about intangible assets, though? Since the values of intangible assets are typically derived through income- and market-based methods, their value is already embedded in income- and market-based approaches to valuing the business. Therefore, if a company has not demonstrated the ability to generate cash flows sufficient to generate a value of the business under an income- or market-based approach that is greater than the value indicated by the asset-based approach, it stands to reason that these underlying intangibles may have little to no value. However, even if the asset-based approach is utilized consideration should be given to the value of the “gross profit” in the backlog as the Company has a contract to complete this work. Thought needs to be given to how much additional value this provides to the Company’s overall value considering there still is risk to perform the work and make the estimated margins.
After analyzing the company’s assets, the valuator moves on to liabilities. Liabilities may be recorded on the books at a value that resembles fair market value (e.g., payables and, in many cases, bank debt). Complicating the matter, however, are unrecorded liabilities. Because accounting requirements do not require every potential liability to be recorded on the enterprise’s books, there may be meaningful unrecorded liabilities such as regulatory claims (e.g., an unresolved IRS audit), legal disputes (e.g., litigation against the company) or, in the case of union contractors, multi-employer benefit plan withdrawal liabilities. While not recorded on the books, these claims and contingent liabilities may have a significant impact on a hypothetical buyer’s perception of the value of the business. Valuation of these contingent liabilities may involve complex modeling. Therefore, these items should be given careful consideration.
As discussed above, the asset-based approach may have been “forgotten” in your construction company’s valuation. You need to find out…was it properly considered and dismissed because income- and market-based approaches indicated a higher value? If so, the valuation report should indicate that. On the other hand, if the asset approach was ignored without any explanation (or not given any weight, even though its value was higher than the income- and market-based approaches applied), it may be worth a conversation with your valuator to better understand his/her basis for doing so. As a take home the asset-based approach is a good rule of thumb when initially considering what a construction company is worth.