Risky Business: Valuation Rules of Thumb

Determining the market value of your construction business may be necessary or desirable for many reasons. Examples include a sale or merger, financing, succession planning, tax and estate planning, insurance claims, divorce, or setting up an employee stock ownership plan. Whatever the reason, it’s important to consult an experienced valuation professional.

Some contractors use rules of thumb — such as a multiple of earnings before interest, taxes, depreciation and amortization (EBITDA) or a percentage of annual revenues plus inventory and tools — to value their business. Although these shortcuts are quick and cheap, relying on them is risky business.

Here’s the problem

Rules of thumb are simple valuation formulas, typically based on industry averages or passed along by word of mouth over time. They’re often based on actual sales transactions in the construction industry but, by definition, they don’t account for the specific attributes that drive your business’s value — such as management talent, location, competition, growth, costs, workforce or reputation. As a result, applying a rule of thumb is likely to undervalue or overvalue your business.

For example, let’s say Contractor A and Contractor B each have EBITDA of $1.5 million. According to a widely used valuation rule of thumb in the industry, each company is worth three times EBITDA, or $4.5 million. The two contractors are nearly identical in most respects, with one critical difference: Contractor A derives 70% of his revenue from three clients, while Contractor B doesn’t rely on any one client for more than 5% of her revenues. Given Contractor A’s higher level of risk, it seems clear that Contractor B is worth more — even though the rule of thumb values them equally.

There are countless other factors that affect value but aren’t necessarily reflected in a rule-of-thumb valuation. Perhaps one contractor has stopped investing in marketing or equipment maintenance, temporarily inflating EBITDA but placing the company’s future earnings at risk, which lowers its value. Or maybe another contractor has done a better job of controlling costs, making it more profitable than the other.

A starting point

The examples above show how valuation rules of thumb often lead to inaccurate results. But that doesn’t mean they’re entirely irrelevant. Rules of thumb can serve as a good starting point for estimating your construction business’s value, and you might use them as a “gut check” against the results of other valuation methods.

But they should never be relied on alone. Only a competent valuator familiar with the construction industry can provide the level of specificity and detail necessary for accurate results.

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