Value of Company 1

[pmadson]

Are there any simple "rules of thumb" that can be used to approximate the value of a small engineering consulting business? This would be used specifically for selling or awarding shares of the company to employees.

Thanks,

Pete Madson

http://www.npcg.net

 

[JAE]

I don't know of a rule of thumb. Two firms that I have worked for have gone through valuations - most recently we used Zweig White

http://www.zweigwhite.com/index.asp

and also our banker to help establish a value. The difficulty is that A/E, A, E, and E/A firms are service companies that have few material assets. Thus, much of the value is made up of reputation, on-going projects, cash flow ability, and "goodwill". These were established for us based upon other firms around the nation that were sold, etc. I do believe there were some rules of thumb mentioned (such as x times the annual gross revenue) but they weren't specifically used in any negotiation or stock valuation.

 

[GregLocock]

Wow, interesting question.

Rule of thumb from a management consultant I used to know - succesful consultancies need to charge 3 times the hourly rate of all their employees.

Next handy rule of thumb - I'd expect a small engineering consultancy to run on a p/e of about 5, for all the sorts of reasons JAE gives, and more.

Hmm, I'll have a bit more of a think about this, and look at engineering share prices. Personally, I don't buy shares in engineering companies, by and large.





Cheers

Greg Locock

Please see FAQ731-376 for tips on how to make the best use of Eng-Tips.

 

[RDK]

A couple of ways to value any company are discounted future profits and asset value.

Asset value is simply that. How much would the company be worth if all the assets were sold. For engineering companies that is a very small number since used computers and desks are really not worth that much. Even if you used replacement value to determine the asset value you would get a very small number. This would set a minimum company value.

Discounted future profits are the profits projected into the future discounted or reduced for the time value of money. That is next year’s profits divided by (1+i) where i is the interest rate. The year after that is divided by (1+i)^2 and so on as far out as you want to go.

The farther you go the less in today’s value is a dollar of profits in the future worth; 5 to 10 years is normally as far into the future that you need to go.

The problem with that approach is that projecting the future is difficult since engineering workload and profits vary greatly. Also as a service company all you gave to sell is the time of your employees. They only have to give 2 weeks notice to leave and then you have nothing to sell.

Often instead of being your employees they are your competition.

Employee turnover is the main reason why engineering companies tend to be employee owned with wide distribution of ownership.

The real value of a small company is the amount that someone will be wiling to pay for it.

A price earnings ratio of around 5 to 7 is usually correct. Earnings should generally be 10 % of net billings so a small engineering firm should be worth about 6 to 8 months average billings. I caution you that this is only a quick and dirty method and may or may not be very accurate in any particular case.


Rick Kitson MBA P.Eng

Construction Project Management
From conception to completion

http://www.kitsonengineering.com

 

[GregLocock]

OK, for a non exact science we are getting close. I was going to say a year's earnings, having looked at a few companies, but you (Rick) are much closer to the field than I am.



Cheers

Greg Locock

Please see FAQ731-376 for tips on how to make the best use of Eng-Tips.

 

[RDK]

One year’s revenue might be the initial asking price.

Valuation of a business, especially one in the service sector is not an exact undertaking and depends on a lot of other factors other than cash flow or profits.

I know a sizable engineering company that had a thriving business working for a utility. The utility went to a business model of having contracts in place where they could demand services and in order to bid the company would have had to sufficient people on staff who may or may not be able to charge $1 for their services unless the utility called for them.

Needless to say they did not bid and lost about 75% of their revenue practically overnight.

They then concentrated on one industrial sector for a few years. They had restored their revenue stream and when that sector went in the dumpster they once again lost 75% of their business.

Now they have a broader client base and while the high revenues are not there neither is there much risk of suddenly drops in cash flow.

A business with a single client or one with a single industry as their client base would be worth less than one with a broad client base.

The rainmakers in a firm who attract the business are a consulting firm’s most valuable asset. If they are also owners they will be more likely to stay and continue to bring in future business so the firm overall will be more valuable. (but there will be less of it available to buy)

Rick Kitson MBA P.Eng

Construction Project Management
From conception to completion

http://www.kitsonengineering.com

 

[JAE]

Also,

Try this site - don't know much about it though,

http://www.valuadder.com/CompanyValuationCalculator.html?AW=cvc

 

[nornrich]

pmadson,

In discussing this matter with my lawyer and accountant, they suggested the consultancy route if you want to spend a lot of money and get a number that may or may not be correct. They recommended the best route to take is to do a self valuation. This entails sitting down with the principals involved and comming to a consensus on what everyone thinks the company is worth. This should take into account any hard assets and should take into account the future sales/profit potential based on past performance. This should be done on an annual basis and should be entered into company minutes. This sets a sellers idea of valuation.

I do know that from a buyers perspective one of the rules of thumbs that are used is 5-7 times the companies Earnings Before Interest, Taxes and Depreciation (EBITD). In a active acquistion market the company can sell at 7 X EBITD. In a slow acquisiton market companies will sell closer to 5 X EBITD range.

Regards,

Rich.....

Richard Nornhold, PE

 

[fndn]

I look for 5 things before considering buying a firm.
1) Are there many small clients that return instead of few large ones.
2) Are the revenues increasing by 10% every year with little seasonal fluctuations.
3) Is the firm free of debt & internal cash flows paying for payroll instead bank line of credit
4) Can I sell this firm in 20 yrs at more than double what I paid for. AND
5) Are the clients willing to stay with the new owners.

If all 5 answers are yes, then why should I care if I overpay by 200 Grand now, when the profits of 20 yrs and the final sale price will more than compensate for it.

 

[RDK]

You should care about overpaying by $200 grand now because buying a business is an economic decision.

Doubling your money is 20 years is only a 3% return. This is slightly over inflation rates for the last few years.

If you are comfortable with that amount then there are a lot of much less risky investments that you can make that will return that rate or more.

Stock market indexes typically pay at least twice that over the long term. As I understand it, US tax free municipal bonds will pay about that amount with no tax issues and a guaranteed return and protection of the principle amount.

The gain would be a capital gain and you would have to take into account the tax treatment of this as it varies depending on country. Your after tax return could easily be negative after adjusting for inflation.


Many small clients lessen the risk by lessening the dependency on any one large client. Just make sure that they are not all in one industry or you can lose them all when that industry enters a downturn.

Or even in various industries that support one industry. An example of this would be in say Seattle where the economy is highly dependant on Boeing Aircraft. Your client base could consist of residential developers, commercial developers and other local industry that all support Boeing. If the international jet aircraft market enters a slump then so does all these other businesses.

Sometimes this is hard to avoid since where I live most of the economic activity is generated by agriculture. If the farmers have a couple bad years then so does all other local businesses. Try for a client base that is immune to this or at least as diversified as possible. Look for clients that might actually do better in an economic slump. Repair places usually do better when the economy goes south since people and businesses are repairing rather than replacing.

There is nothing wrong with seasonal fluctuations as long as you can adjust your expenses to meet these fluctuations, where I live construction is still a seasonal undertaking especially civil works in horizontal construction. Summer students and seasonable work force allow businesses to adjust to this variation in income by reducing expenses during the off season.

Nothing wrong with internal debt as well, as long as there is sufficient cash flow to cover it. If you are buying into the company (as opposed to buying out another shareholder) the proceeds from your purchase could be used to pay down this debt or expand the firm.



You have to look at all the factors and not consider any one in isolation from the others. In any economic decision you have to consider other opportunities for the money.

Locally a lot of farmers have upwards of a few million invested and are only making a bare living. If they sold out and put the money into other investments they could easily triple or more their net income. They are paying heavily for the lifestyle.

Only accept a lower return financially if the other benefits of ownership (pride, self satisfaction, lifestyle etc) are worth the lost opportunity. That is an issue that only you can answer.

Rick Kitson MBA P.Eng

Construction Project Management
From conception to completion

http://www.kitsonengineering.com