It is important that you have a comprehensive understanding of the three primary methods used to estimate the fair market value of your company and the eight factors to consider in valuations of a closely held business.
Typically, the owner of a construction company works a lifetime to build a business and provide financial security for their family. Then, upon ownership transfer of the company to family members or other individuals, federal and state taxes can take a large chunk of the equity built up in the company.
Proper tax planning and a sound business valuation can reduce all or a large part of these taxes. Estate and gift tax planning is the most common reason for needing a business valuation, but the following life-events are of equal importance:
- Marital dissolution
- Employee stock ownership plans
- Liquidation or reorganization
- Financing opportunities
- Private equity purchase
- Initial public offering
- Buy-sell agreements
- Damages litigation
- Insurance claims
- Eminent domain actions
Whatever the reason is, the goal of a valuation is to determine a “fair market value” for the company. The IRS defines fair market value as, “The price at which the property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, and both parties have a reasonable knowledge of the relevant facts.”
In 1959, the IRS issued a ruling which is regarded as one of the most important concerning the valuation of a business. Although the ruling was intended for estate and gift tax purposes only, the IRS later expanded its applicability.
The eight basic factors to consider now in a valuation of a closely held business are:
- The nature of the industry and the history of the company from its inception.
- The general economic outlook and the specific condition and outlook of the industry.
- The book value of the company’s stock and its financial condition.
- The company’s earning capacity.
- The company’s dividend paying capacity.
- Whether the enterprise has goodwill or other intangible value.
- Stock sales and size of the blocks of stock to be valued.
- Market prices of stocks of corporations engaged in the same or similar line of business, having their stock actively traded in an open and free market, either on an exchange or over the counter.
Methods to Compute a Fair Market Value
The two most important factors that affect the value of a construction company are the present value of future earnings and the market for the company’s net assets. The value of a company is based on some combination of these two factors.
Earnings reflect the enhanced value of a company because the assets are assembled together in a manner that is more productive than if separate. This additional combination of goodwill, going concern value, and favorable contractual agreements.
The three primary methods available to estimate the fair market value are:
- Discounted income approach
- Market approach
- Adjusted net worth approach
Discounted Income Approach
This approach draws on the concept of discounting the company’s estimated future stream of income or cash flow to its present value. The estimated value of the company is represented by the sum of the annuity value, the present value of the income stream earned over a five-year period, and the reversion value, the present value of the net equity realized at the end of the five-year period.
The first step is to compute the company’s estimated earnings or cash flow over each of the next five years. The number could be based on an average of prior years and then should be adjusted for any excess amounts paid for expenses such as:
- Owners’ salaries or compensation
- Rent or lease expense
- Owner perquisites
- Entertainment expenses
- Automobile expenses
- Compensation to family members
- Depreciation and amortization
The second step is to determine a present value or discount rate to apply to the future years’ income or cash flow. The discount rate mainly represents the risk or the uncertainty related to the achievement of the forecasted earnings.
Finally, a reversion value or capitalization rate should be selected to reflect the value of the company at the end of five years.
Exhibit 1 below uses an estimated future annual earnings of $500,000, a discount rate of 20% and a reversion value of 11%. Under this scenario, the estimated fair market value of the company would be approximately $3,322,118.
Discounted Income Approach
*Reversion value calculated by estimating the current market value at the end of the fifth year at an 11% cap rate applied to the earnings of $500,000. ($500,000 x 0.4019) / 0.11 = $1,826,818.
The market approach is to determine the value of contractors, whether privately held, held by a private equity group, or a publicly traded construction company and compare its value to your company.
The first step is to select and evaluate publicly-traded companies engaged in a line of business similar to your company. Then determine the “market price multiple” of this similar company’s most recent year’s earnings or cash flow as compared to the price of its stock. Finally, the “price to earnings multiple” is applied to your company’s forecasted earnings.
Exhibit 2 below assumes the same future earnings of $500,000 and an estimated price to earnings ratio of 6 to 1. Under the market approach, the estimated fair market value of the company is approximately $3,000,000.
Adjusted Net Worth (Book Value) Approach
The underlying assumption of the adjusted net worth approach is that the company’s value is equivalent to the sum of the current value of the company’s tangible and intangible assets less its outstanding debt.
This method is applied by substituting the company’s fair market value of assets for its book value. This method is most applicable to paving, excavating, and other construction companies that own a facility and a significant amount of land, property, and equipment.
The quickest way to compute the value of the company is to determine the fair market value of the assets of the company and add the excess value over the company’s book value to the equity of the company.
Exhibit 3 below identifies a construction company that has a stockholder equity book value of $2,750,000, while the equipment owned by the construction company is worth approximately $800,000 and has a book value of $500,000. In addition, the company owns land worth $400,000 that was originally purchased for $200,000. Under the adjusted net worth, or book value, approach, the estimated fair market value of the company is approximately $3,250,000.
In addition to these methods, the fair market value of a construction company may be subject to other factors that may increase or decrease the company’s value.
Adjusted Net Worth Approach
Discounts and Premiums
The final value of a construction company may be greater or less than the value calculated using the methods described here. The use of discounts or premiums may be appropriate in calculating the final value of the company. Two common discounts and premiums are:
- Minority discount. This exists when a new owner holds less than 50% of the company and lacks the ability to control the company.
- Control premium. This exists when an equity holder attempts to purchase another equity holder’s interest.
The amount of the discount or premium should be added to or subtracted from the value of the company as computed under the three methods above to arrive at a final value of the company.
The methods described here are only a part of the valuation process and should not exclude other internal or external factors that may reduce or increase the company’s value.
We have extensive experience in estimating fair market value for all trades in the industry. For help or questions, please contact Tim Cummins or one of our construction specialists at 301.231.6200 for an in-depth analysis and determination of your company’s estimated fair market value. For further on this topic, please read our other blogs, “What’s it Worth to You? Why You Want to Know Your Construction Company’s Value,” “Two Methods for Valuing Your Construction Company,” and “Risks Impacting the Value of Your Construction Company.”