Valuing a construction company presents unique challenges. Some of the valuation topics unique to construction companies are construction methods of accounting, retainage, under/over billings, backlog, and the business cycle of the construction industry. Additionally, a contractor that bids public work or is unionized versus one that relies predominately on private work plays an important role in the valuation.
A valuation analyst must understand construction accounting to properly asses the income and balance sheet of a construction company. Construction accounting methods for long term contracts include percentage of completion and completed contract as the most widely used methods for tax purposes. The percentage of completion method recognizes the revenue and expenses of long term contracts as a percentage of the work completed during the period and is primarily the method of choice for Generally Accepted Accounting Principles financial statement reporting.
The completed contract method recognizes all revenues and costs in the period in which the contact is completed and may be the method of choice from a tax perspective. This method may distort income as revenues and costs are not recognized in the period earned or incurred. The delay in income recognition also allows a company to defer income taxes to future periods. This method is only available to construction companies with three-year average gross receipts of less than $25 million. This amount was raised from $10 million to $25 million as a result of the Tax Cuts and Jobs Act of 2017.
Construction contracts often have a retainage or retention provision that allows customers to hold back a percentage of the payment until the job is completed as promised. Typical retainage withholdings range from 5% to 10%. The retainage provides an incentive for the company to complete the job to the satisfaction of the customer. It is important to analyze the retainage of the in-process contracts.
A unique balance sheet account to construction companies when the percentage of completion method is used is billings in excess of costs and estimated earnings, also known as over billings. This occurs when billings on uncompleted contracts exceed the income earned on uncompleted contracts, and is recognized as a liability on the balance sheet. Conversely, costs and estimated earnings in excess of billings, also known as under billings, occur when billings on uncompleted contracts are less than the income earned on uncompleted contracts. Under billings are recognized as an asset on the balance sheet. Overbillings should be looked at carefully. The company may be using the overbillings (the customers cash) to finance the job and defer income taxes.
The value of a business depends on the future economic benefits that will accrue to the owner. Although historical results can be a reliable indication of future performance, that is not always the case. The valuation analyst must carefully analyze the company it is valuing, the industry, and the economy. A key indicator of future performance for a construction company is its backlog. Backlog represents contracts that the company has obtained and are contracted to perform the work in the future. A company with a large backlog of profitable jobs will be more valuable than a company with a small backlog of unprofitable jobs. Industry and economic forecasts are also key to the future performance of a company.
The business cycle of the construction industry is sensitive to changes in the overall economy. There is often a lag in timing between the overall economy and the construction industry. For example, if the economy dips into a recession, construction companies may still have work as the contracts have been secured for the jobs. The business cycle of construction companies often varies based on the segment they serve (commercial, residential, infrastructure, etc.).
The public work sector relies heavily on funding sources from governmental agencies in an open competitive bid environment. It is common for profit margins to swing considerably with out of scope work being difficult to collect as each project has its distinct characteristics and tight funding source. Private work on the other hand sometimes is less competitively bid, is more customer focused and may offer the ability to be value added. Another challenge the valuator must assess is the entity’s workforce, talent pool, safety and training and union versus non-union. The more an employer can control the workforce and drive efficiencies in the field and have a favorable safety and insurance record the more profitable they may be on a consistent basis. Addressing union matters and ability to access the non-union bid market is becoming more and more important and many large scaled projects by developers are being bid open shop. As the market changes a strict unionized labor force may present future challenges.
Valuing a construction company presents many unique challenges. A valuation can be off the mark if the points discussed above are not understood. Please contact Withum’s Forensic and Valuation Services group or Construction Service Team for more information.