AE Advisor Morrissey Goodale
Valuation 101 | A primer on A/E firm valuations

The Three Approaches to Valuing a Firm

The Death of Annual Performance Reviews?The commonly used methods of valuation fall into one of three general approaches: the asset-based approach, the income approach, and the market approach. The asset-based approach uses a firm’s book value or an adjusted net asset value to derive a valuation based on the value of a firm’s assets net of liabilities. Asset valuation is generally straightforward and easy to understand. However, it ignores the true drivers of revenue and profits in the A/E industry because it is based on physical assets (vehicles and computers) and not on intangible assets such as design or marketing skills. If you’re working with a valuator relying heavily on net asset value, we suggest you question whether the advisor has a strong grasp of the A/E industry.

Better approaches in the A/E industry are the income approach and the market approach. The income approach determines value by converting anticipated economic benefits (income) into a present single amount. An advantage of the income approach is that it considers the economic benefit stream generated by the enterprise, which most directly measures an A/E firm’s true worth. The drawbacks, however, are that it relies on future projections and assumptions, which may or may not occur, and requires significant analysis to estimate and quantify.

With a market approach, the value of a firm can be determined by referring to reasonable comparable guideline companies. The upside of the market approach is that it’s readily accessible and easy to understand as the market gives a direct indication of firm value. The downside, however, is that comparable firms can be difficult to find and reliable data may be hard to obtain first-hand since industry transactions are infrequent.

Curb Appeal | Tips for getting your firm market-ready

Make Cash Flow Your Top Priority

The Death of Annual Performance Reviews?The worth of a thing is the price it will bring. That’s easy enough to grasp when looking at stocks listed on a public exchange or even when buying an illiquid asset like a home, where a robust and active market exists for buyers and sellers. But what about small, closely held firms that constitute the bulk of the A/E industry, which transact far less frequently and on terms seldom made public? How do we establish a value for a firm and then make it more attractive to potential buyers? Two words: CASH FLOW.

More than any other metric in this industry, the free cash flow (the cash each year that actually flows to the owners, after expenses and apart from accounting charges like depreciation) to the firm provides an indication of value. The more free cash flow your firm generates, the more attractive it will be. Period.

Your firm may have an A-list set of notable clients in hot market sectors or high-growth geographies, but if your firm only earns a penny or two in profit for every dollar billed, the resulting enterprise value of your business will make you want to get into the fetal position and cry. That’s because the single-best means that buyers of a design or environmental consulting firm have to gauge a firm’s value is the profits generated by the business. The more cash flow you can demonstrate in recent years and the more cash flow you may reasonably expect the firm to see in the near term, the more attractive your firm will be in the eyes of buyers, internal or external. To build attractiveness, focus on building the most profitable operation possible. But don’t do so by eliminating marketing or cutting other investments that will grow the firm in the long term; a contracting business won’t inspire any buyer to pay a premium.

Maximizing Wealth | Get the most out of your firm investment

Does Your Firm Have a Hoarding Problem?

The Lunch Break’s Dying DaysCash is king, right? After all, it’s hard to have a business—let alone build wealth—if the goose that’s supposed to lay the golden egg dies because no one had the cash to feed it. Well, that’s sometimes true, but the problem is we often see firms with a cash-conservation approach forsake the opportunity to maximize wealth. In fact, we often see businesses of 20 staff or smaller carrying hundreds of thousands of dollars of excess cash on their balance sheets. The problem can be magnified many times over in larger firms.

We know why. As design professionals, we’re trained to expect the worst-case scenario—like a 1,000-year flood event—and then plan against it. The same thinking goes into managing firms and, especially in closely held businesses that represent the owners’ greatest assets, the desire to retain excess cash runs high.

But the problem of excess cash is one of opportunity cost. Suppose an abundance of management caution leads to a failure to invest in the firm and build long-term wealth? That extra hundred grand could pay an additional staff engineer, freeing up his or her manager to win more work and increase the value of each owner’s shares. A firm may also choose not to open a new office or invest in a new technology, losing a competitive advantage. The temptation to hoard cash to feel secure in the short term is strong, but long-term wealth creation will only come with growth. Don’t forget to fund it!