Archive for September, 2008

Heating, ventilation and air conditioning as well as plumbing contractors make up a very large industry with over $121 billion in annual gross revenues.

The industry is still highly fragmented with some 178,550 independent business competing across the US alone.

The average business in this industry, classified under SIC 1711, is privately owned and small – with $700,000 in annual revenues on average, employing 6 full time equivalent staff.

Factors that drive company valuations

Successful HVAC and plumbing contractors tend to focus on the service they provide to their target market. Differentiation is key to profitability and business owners must make key decisions on what service mix to offer to their commercial or residential clients.

Location of the busines premises is not as critical as say, for retail stores, because HVAC and plumbing contractors travel to their customer sites. However, local offline and online advertising visibility is very important for new business, as are referrals from your existing customers.

HVAC and plumbing contractors need to generate steady repeat business to smooth out income fluctuations. Ongoing service and maintenance contracts can be extremely useful for sustainable profitability.

Being flexible and in tune with emerging market trends is the hallmark of successful contractor businesses in this industry. Your profits, and company value, depend strongly on how well the service mix fits in with the current market needs.

Business valuation methods for HVAC and plumbing contractors

HVAC and plumbing contractors sell often, so there are private business sale comps you can use to come up with accurate valuation multiples in this industry.

The typical valuation multiples for these companies are:

  1. Price to annual revenue, plus inventory.
  2. Price to SDCF, plus inventory.

Valuation Multiples by Industry

Why these valuation multiples?

We continuously analyze the private business sale comps in many industries. To select the best valuation multiples for a business, we look at the business selling price spread, low to high, in comparison to the average selling prices. In math terms, we look for the valuation multiple with the lowest coefficient of variation.

You can estimate your business selling price more accurately using the valuation multiples that show the relatively low variation around the average selling price.

Because most business buyers and sellers use them

What this means is that business buyers and sellers in your industry tend to rely on these valuation multiples more often to price their deals.

To get reliable estimates of business market value

Using such valuation multiples, you can come up with an accurate estimate of what your business is worth on the market.

Business valuation based on income and risk

For business appraisals of owner-operator managed businesses, you can use the Multiple of Discretionary Earnings business valuation method.

The method lets you calculate what your business is worth based on its earnings and 14 important financial and performance factors.

What is your business goodwill worth?

For well-established HVAC and plumbing contractors that have been around for a number of years, the question of business goodwill is important.

You can use the well-known Capitalized Excess Earnings business valuation method to determine the value of business goodwill – an important part of the total business value.

There are no better indicators of what a business is worth than its earning prospects and risk profile. Savvy investors analyze business opportunities by doing careful forecast of their income. But forecasts and money in the bank do differ in one key respect – there is a risk that the business may not live up to your expectations.

Hence, business value depends upon its risk assessment. Well-known income-based business valuation methods, such as the Discounted Cash Flow, let you account for the business risk directly – via the appropriate discount rate.

Alternatively, you can use the capitalization rate to factor in the company risk when valuing a business. The direct capitalization business valuation methods, for example the powerful the Multiple of Discretionary Earnings, let you do just that.

Since the discount and cap rates are related via the business growth rate, you can use both business valuation techniques.

Given the importance of company risk assessment via the discount and cap rates, how do you determine these important factors?

Do they depend on the economic conditions? Also, do the discount and cap rates change over time?

Each company has its own risk profile. Not surprisingly, the discount and capitalization rates for each business will differ. Here is how the discount rate is determined using the famous Build-Up formula:

  1. Start with a risk-free return.
  2. Add a risk premium for equity investment.
  3. Add another risk premium for small company size.
  4. Add a risk premum for the industry the company operates in.
  5. Finally, add the company-specific risk premium.

Risk-free investments do pay!

Risk-free return means no risk of default. Investors like to use the current yields on long-term government debt obligations, such as the US Treasury bonds, as a measure of the current risk-free rate of return.

Even the most diversified stock investment portfolio is risky

You can examine the prevailing rates of return across the stock market to determine the additional returns the investors get for putting their money into publicly traded companies. This additional return is the premium required to keep investors interested in these companies, given their risk.

Small companies are riskier still

Small firms are seen as more risky than large ones. Again, you can study the market to see that the so-called “small cap” companies tend to generate higher returns. The additional return is the company size risk premium that can be used in the Build-Up formula.

Business risk varies by industry

Each industry has a set of unique risks that companies must overcome to be successful. You can study the returns in the specific industry in comparison to the stock performance across the entire market. The difference in the returns is the industry risk premium. Note that this number can be negative – if the industry is seen as less risky than the market as a whole.

Each company has its own risks

No company risk assessment is complete without analyzing its own set of strengths and weaknesses. Decisions made by the company management such as financial leverage, entering and exiting certain markets, hiring skilled staff, and making critical investments affect the company’s income prospects and its risk. Your goal here is to assess how these factors translate into the company-specific risk premium number.

Your business risk changes over time – so does business value

If you glance at the Build-Up formula elements, it is clear that the overall discount rate will vary over time.

Risk-free returns vary based on the prevailing interest rate climate. Public company fortunes change, so do their returns. Small companies may become a haven for investment money in some markets.

Industries go through cycles of expansion and contraction. And, of course, strategic decisions in the company itself affect its own risk.

It is a good idea to revise your risk assessment at least annually. This helps smooth over any transient effects in the markets and lets you spot important trends.

Tools to calculate the discount and cap rates

ValuAdder 4.0 business valuation software contains several tools you can use to assess the risk of any company.

Using the latest market data, ValuAdder financial recasting worksheets let you build up your discount rate, calculate your capitalization rate and account for the various business financing scenarios – with different costs of debt and equity capital. 

Business Valuation Tools

Any business appraisal, whether prepared by you or someone else, depends on the assumptions made at the outset. Take a look at a well-prepared business appraisal report and you will see that, how the business value is measured as well as the circumstances of business appraisal, are clearly spelled out.

In addition, assessment of business worth requires informed judgement calls from the author – whether the business person or professional appraiser. How you view the business income generation prospects and translate them into the financial forecast makes a difference to the calculated business value result.

Business risk estimation, subject to your judgement, shows up as some pretty important numbers in the form of discount and capitalization rates. These, in turn, affect the outcome of your business valuation calculations.

So, it is not surprising that two appraisals of the same business may give you different results. How different? It is not unusual to see variations on the order of 20 – 25%. Put another way, a well-done business appraisal really establishes business worth within a range of values, not a single number, down to a penny.