Public financial markets value companies based on their ability to earn money into the future. Financial analysts apply a multiple to the current proven earnings of a given publicly traded company in an attempt to accurately predict the value of future earnings. Valuation is about earnings.
There are 3,759,710 construction businesses in the U.S. as of 2022 and only 17 are publicly traded. How can this be? Why hasn’t the construction industry tapped the public capital markets for the funds it needs to grow like every other industry? When considering the size and long history of construction it seems almost impossible that the public markets have not clamored to invest. Why not?
The unique nature of the construction business makes it virtually impossible to assign a value to future earnings based on current earnings. Here’s what’s unique about the construction industry and why it is difficult to value future earnings:
- No uninterrupted revenue flow – Contractors are paid for services one project at a time. They compete in the market, project by project. Every new project is virtually a new business.
- Current earnings are too hard to isolate – Because each completed sale takes place over a long time period and is generally paid for after the next overlapping project has already begun, it is hard to isolate earnings at a specific cutoff date like traditional corporate accounting under GAAP rules. (Think accuracy of cost to complete.)
- Current earnings are not a reliable predictor of future earnings – Future earnings flow from new projects that are often nothing like projects completed in the past. Risk factors are different – margins vary widely – market conditions are volatile – new personnel may be involved as each new project follows the last. In other words, few factors in the contracting business are consistent from one job to the next.
- Construction services are undifferentiated – The essential construction services provided by one contractor or another are similar in nature and seen as a commodity in the marketplace. Only the experience and reputation of a contractor differentiates them from the competition – (which we will discuss further).
- And finally, the contracting business model is too complex.
- A general contractor or construction manager farms out much or all of the work to a series of subcontractors who provide the services the general or CM contracted for.
- It is impossible to evaluate the general contractor’s or CM’s ability to earn without evaluating all the subs as well. The work of all project partners must be coordinated carefully and a minor failure of one usually has a ripple effect on the subs down the line.
- The duration of a typical construction project is often measured in years rather than months which makes outcomes problematic in volatile markets. Predicting profitability even one job at a time is a difficult task when the time to completion and final payment takes so long.
I have been preaching the importance of profit to the construction industry for more than 30 years and most of my exhortations have fallen on deaf ears. Now I know why. Contractors, sureties, and bankers have figured out that traditional business principles do not apply in exactly the same way in our non-traditional contracting business. No contractor, surety, or banker would ever say it this bluntly, but they all seem to understand something that I did not realize. They are not as fixated on profit as I am. They believe:
The valuation of a contracting business is not based on its ability to earn money.
The value of a contracting business is determined by its capacity to conduct business into the future at an increasing rate. (growth)
The key word is – capacity.
When a contractor begins to build his company from solo-entrepreneur to a firm that can contract for $50 million of services annually, he adds professional staff, equipment and tools, reputation, financial relationships with bankers and sureties, office space, and access to capital to ensure an uninterrupted workflow and potential for growth. In short, they have created capacity. They have created the collective ability to acquire and complete projects in the future. They are a “going concern”. They have created “value”.
For the next three weeks this blog will look more carefully at this concept of capacity. What are the elements of capacity? Why is capacity the intuitive goal of every contractor? How do contractors learn to add value (capacity) to their companies as they go along? See you next week.
Details on these issues in my latest book The Secretes To Construction Business Success, published by Routledge https://bit.ly/3G9ornf.
For a deeper look into financial management, read more here: FINANCIAL MANAGEMENT
For a broader view into growth, read more here: GROWTH
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