The purpose of business is to make money. “Making money”, however, means different things to different people. To an employee, for example, it means to have a job and get paid a wage. To an owner, on the other hand, it means to realize a reasonable return on your investment. In the construction industry, the transition from trade employee to small business owner is the traditional path for contractors. Often, however, contractors do not make the conceptual transition from employee to owner when it comes to making money. Even after they start their own construction company, most still see making money as maintaining a “going concern” that can provide their income. They seldom see the company as a separate entity that has a value over and above its ability to pay them an ongoing good wage.
The Value of Earnings
Construction contracting is a service. For the purpose of valuation, it is not an asset-based business, and accumulating meaningful book value is not the primary objective. Some assets (equipment, office, shop and storage space for example) may be acquired along the way, but the market value of a construction business is solely its ability to generate profit over time. It’s the earning power of a construction business that determines its value. However, this simple statement hides a nuance or two. What do we mean by earning power? How do you determine earning power? How do you derive value from earning power?
The Market Determines Value
Investors changed their definition of value over time.
- In the first half of the twentieth century, stock investors valued companies primarily on “book value”. Book value was determined by the firm’s equity at a given moment in time. Depending on their evaluation of management’s ability to not only maintain the book value but also to make it grow into the future, investors would assign a “multiple” to the book value. If they thought management was solid and the company’s market position entrenched, they might assign a multiple of 10X (10 times) book value and divide the sum by the number of shares outstanding to arrive at a share price.
- After the turn of the mid 20th century (approximately the 1960s) investors began to value companies based on their “earnings”, rather than their “book value”. They began to see a company’s earning power as a more accurate measure of its future value. Young companies whose earnings were growing were often assigned a multiple of 20X current earnings and mature companies would be assigned a more modest multiple of perhaps 10X current earnings.
- Toward the end of the 20th century with the advent of innovative technology companies, investors began to assign valuation multiples to a company’s implied earnings. Although the company may be making no money in the present due to the costs they are incurring in product development and promotion, the tech products they are selling or going to sell would dominate the market far into the future and earn money for years to come (implied earnings). Multiples from 40X to infinity were assigned to the implied earnings of these innovative technology companies.
Construction Industry Valuation
Construction companies are rarely traded on public stock markets, but remain, for the most part, in the private sector. Their valuation is usually based on their ability to earn money and, when acquired by competing larger firms, enjoy a modest multiple of earnings in their valuation. A founder/private owner of a construction company is often building their firm for their family to own and operate in the future. Although they may not realize it, they are planning their company’s ability to earn money for the family into the future, thereby assigning in their mind a multiple to its current earning power. That is an “implied multiple” of earnings valuation in its most “closely held” form.
Earning Power
A construction company is not a product-based business. It is a service organization of skilled construction professionals that provides collective construction skills to government agencies and private owners. The question arises, how do you determine the future earning power of a service? What organizational, financial, and technical factors contribute to a contractor’s ability to make money over time?
There are three main profit components that determine a construction company’s earning power:
- Managerial Maturity
- Financial Capacity
- Market Position
Evaluating your company’s profile in these three profit components will tell you your company’s current earning power.
As economic conditions change, it is essential to the long-term success of construction companies that top management assign an economic value to their company independent of the company’s ability to provide them with a wage.
Next week we’ll discuss how to evaluate each of the three profit components.
For more information on valuation read more at: VALUATION
For a broader view on earnings, read more here: EARNINGS
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