With the recent wave of mergers and acquisitions in the landscape industry,
many owners ask what is the right multiple of earnings to apply to a company. "Don’t firms sell for 3 to 5 times free cash flow?" The answer is many companies do, but simply using such conventional wisdom can lead to a grossly inaccurate valuation of a target firm.
First, recognize the breadth of a range of multiples between 3 and 5. A
multiple of 5 is 67 percent greater than a multiple of 3. Picking the midpoint of 4 may provide a certain appeal, but may be too high or low for the firm in question.
Second, remember that the selection of a multiple is firm specific. The risk
of the firm being valued will determine the multiple applied to that company’s earnings. It is incorrect to say that all firms in a specific trade, market or sector command the same multiple.
Third, many sellers automatically assume "free cash flow" is income before
interest and taxes plus depreciation and amortization. This add-back of 100 percent of the depreciation/amortization expense assumes that there are no annual capital expenditure requirements to repair, replace and upgrade equipment.
Fourth, deciding what figure represents an accurate representation of the earning and cash flow generating ability of a business is much more difficult
for firms which perform commercial construction work. While a detailed
discussion of computing a company’s earning capacity is beyond the scope of
this article, it is generally appropriate to examine several years of income
and cash flow to gain a perspective on future earnings power.
Fifth, there is truly a broad range of quality of firms in the industry. Many firms are not worth even 3 times earnings. There are some that are worth more than a five multiple. What is required is a thorough analysis of the specific company being evaluated. Listed below are ten critical areas to examine and consider when arriving at an appropriate multiple for a construction business.
1. Bid or negotiated
Does the firm perform bid, negotiated or both types of work? How successful
have they been at each type of work? Who are their typical competitors on
jobs? How much of their work is bonded?
2. Work mix and job size
What is the mix between commercial and residential? How successful has the
firm been at each type of work they perform? What has been the average profit margin for each line of business? Is typical job size increasing, decreasing or staying the same? How have they done on jobs further away from home?
3. Profit history
It is fairly standard to examine at least a five years history of income
statements. How consistent have sales and margins been? What has been the
profitability by division or type of work? Have margins increased or decreased over the last five years?
4. Growth
Have sales been growing or declining and why? Have sales grown at the
expense of profits? How have sales fared relative to the available work in the
area over the last five years?
5. Management depth
Is the firm highly dependent upon the founder or major owner(s)? Who has the relationships with clients? What is the tenure of key employees?
6. Clientele
Is the firm overly dependent upon one client or sector? How has the mix of
business changed over time? Who is responsible for growing each type of
business? Does the company deal directly with the client or act as a sub to
the general contractor?
7. Equipment
How much equipment is owed vs. rented? What is the age and condition of the equipment? How is the equipment charged to jobs? What is the utilization
rate for the equipment?
8. Market outlook
What factors have historically driven the economies and especially the
construction markets where the firm operates? How volatile have these
markets been? Where is each of the markets in the economic "cycle"? How has the company performed in up and down markets?
9. Balance sheet
What are the levels of standard financial ratios (quick, current, debt, etc.)? How quickly does the firm collect its money? Is the company significantly over or under billed? Is the company performing a large volume of work on a small equity base?
10. Backlog
What is the size and duration of jobs in progress? Are there any very large or complicated projects? How accurate has the firm’s work in process schedules and job estimates been?
Like many parts of the valuation process, determining a multiple involves both experience and sound judgment. Recognize that determining an earnings multiple is only one factor in the structuring of a successful transaction.
Donald F. Shelly, Jr., of The Construction Group, LLP, is a consultant
specializing in the areas of business succession planning, mergers &
acquisitions, family business, employee ownership and valuation. He may be reached at 303/691-3751.