Valuation of Construction Companies during the COVID-19 Pandemic
Many construction companies have been able to weather the economic shutdown caused by the coronavirus pandemic, but the impact on the industry is still unfolding. The classification of construction as an essential activity in some states and pre-existing backlogs allowed many operators to mitigate the negative impacts early on. However, the deleterious longer-term effects are now hitting contractors as they look forward.
As reported in the Second Quarter 2020 Marcum Commercial Construction Index, contractors recorded an average of 7.8 months of work under contract in July 2020, down a full month from a year prior. Unfortunately, many contractors are experiencing intense competition as existing contracts are completed, backlogs decline, and fewer opportunities to bid arise. As pre-existing backlogs recede, companies must assess their current positions to strategically plan for the future.
The uncertainty is particularly worrisome for business owners who are spending an enormous amount of time working to ensure their company will make it through the pandemic. While the timing may seem strange, many business owners are seizing the current opportunity to move forward with long-delayed succession and estate planning. The impetus is the potential opportunity to transfer or gift business ownership interests at lower values, which can effectively reduce gift and estate tax liabilities. Consequently, the timing of a valuation is critical in order to take advantage of the current ability to transfer greater amounts of wealth with lower tax consequences.
There are multiple mechanisms with which to perform these transfers, and estate attorneys and accountants will help plan the best approach. However, most of the approaches require a business valuation.
Construction companies are among the more challenging to value. Various factors — including revenue recognition convention, fixed asset and debt structure, bonding capacity, backlog, reliance on key personnel, customer concentration, and the economic environment — are all significant in valuing construction companies. These factors can influence the appraiser’s selection of the most appropriate valuation approaches and methodologies. Therefore, it is imperative for a business appraiser to understand the unique nature of construction companies when performing a valuation in this industry.
There are additional factors that any business owner and appraiser should consider in the valuation of a construction business against the backdrop of the COVID-19 pandemic:
- The implications of PPP loans to value. Are they assumed to be forgiven or treated as debt?
- How to consider a market approach. Typically, appraisers look to transaction databases to understand industry multiples of value. In times of disruption, it can be difficult to find current transactions that illustrate the impact of the pandemic on values. An appraiser needs to determine if historical transactions are relevant at all, and if so, how to adjust them to reflect the current contracting environment.
- Relevance of past financial results and whether they are indicative of future performance.
- Diminished backlog and how that will impact future financial performance.
- Use of forecasts and a discounted cash flow model. Unfortunately, contractors have a particularly hard time projecting income because of the variability of earnings from projects, change orders, and the flow of contracts. Because of this, forecasts are less frequently used in valuing construction businesses compared to other industries. However, with an expected slowdown, and consideration of items 3 and 4 above, now may be the time to attempt to forecast earnings, at least for the next year.
- Value of a business’s underlying assets. For many types of contractors, the company’s heavy equipment may be the best indication of value during a slowdown. In fact, after the 2008 recession, many construction firms were valued based on the economic value of their net assets for this very reason. If a company’s expected earnings have taken a significant hit, this method may again be appropriate. In addition, equipment values may also have fallen because of the pandemic. This, in turn, requires an equipment appraisal to determine the value of fixed assets.
- Impact of market volatility. While U.S. public equity markets are showing surprising resilience, the question remains as to how to consider the earlier volatility and the impacts on privately held businesses.
- Discounts for lack of marketability. Transaction activity slowed in the first two quarters of 2020. Increased difficulty in finding buyers and closing transactions indicates an increase in illiquidity. The result can be increased discounts for lack of marketability and a further decline in values.
Valuations are forward-looking and, therefore, rely on predictive techniques to derive the value of a company. While a company’s historical trends have historically been informative, times of disruption require owners to work closely with a qualified appraiser to ensure the impact on future earnings seen by a particular company is not overlooked in properly assessing its value.