By Tyler Thompson and Will Swearingen
Zweig Group recently released the 2021 Valuation Report of AEC Firms, an annual publication administered by Zweig Group for nearly 30 years.
When it comes to estimating the value of a business enterprise, it is important to understand exactly what is being valued and for what purpose. Without an established market in which a firm’s shares are actively traded, an appraiser can only estimate the market value through the application of pertinent measures and indicators of value from relevant data. The compilation of data contained in this report is intended to provide benchmarks and metrics that allow firms to see how their own value ratios compare to industry norms.
This report contains six different value ratios (value vs. FTE count, net service revenue (NSR), EBITDA, pre-tax, pre-bonus profit, backlog, and book value), comprising Zweig Group’s Z-Value formulas. Four different values (Z1, Z2, Z3, Z4) are calculated based on the reason for the valuation. For example, the Z3 formula is determined by valuations that were done explicitly for internal ownership transitions. Each Z-Value represents a different cross section of the survey sample, and indicates value based on different circumstances.
Zweig Group looks back on 10-years of valuation data to capture trends, consistency, and variability in these metrics. This most recent report revealed that over the past decade, Value/FTE showed the greatest degree of change from year to year. This metric continues to increase at a steady pace (roughly 4.4 percent per year) as inflation and cost of living increases drive material and labor prices up. For similar reasons, Value/NSR, generally a more stable metric, showed a higher degree of year over year change (2.1 percent increase) than the cash flow metrics; Value/EBITDA and Equity value/pre-tax-pre-bonus profit. Over the 10-year period, Value/EBITDA showed 0 percent change even though it fluctuates the most in certain cycles.
Of note was how the political cycles in 2012 and 2016 impacted cash flow metrics. The level of uncertainty in the market during those periods created more perceived risk, impacting forward looking valuation model, creating a downward trend on these value multiples during election years.
In 2020, one of the weirdest political and economic cycles in modern history, one would expect to see a similar if not deeper dip in the cash flow multiples, as trade, tourism and economic engines around the globe ground to a halt. Government intervention buoyed the fallout by approving trillions of dollars of aid for the US market, while the greater global response also stabilized the impacts from the pandemic. The 2020 recessionary period was perhaps the deepest decline since
1945 by a series of economic indicators; including contraction of GDP growth, declines in retail and oil demand, rising unemployment, etc. Though it was extreme in many regards, it may also be one of the shortest recessionary cycles in recent history.
Zweig Group’s 2021 valuation data indicate that most metrics followed their historical patterns of slight year over year increases. The only metric that bucked the trend was the Equity value/Book value metric. PPP funds and the ambiguity around their forgiveness created swollen balance sheets with most firms carrying large cash positions into the new year. Historically firms have caried about 15 percent of their total assets in cash. At the end of 2020 firms had nearly 30 percent of their total assets in cash. This is important to note because many smaller firms in the industry think that their cash and AR are their value. Yes, those represent real tangible value, but a firm’s ‘fair market’ value is more closely associated with a firm’s confidence in their ability to generate cash flow on a forward-looking basis.
Valuations conducted for the purpose of gaining a controlling interest in a firm yield higher values than those conducted for minority interest transactions (most internal ownership transfers). This year’s median minority interest discount was 18 percent. Eight percent of the sample also applied additional discounts, on top of the minority interest discount, for key personnel leaving the firm and other non-numerical factors. This year Zweig Group saw an increase in the number of formal valuations submitted with nearly 51 percent of the sample representing valuations done by an appraisal and not a formula. The increase in ownership transition activity across the the industry has prompted more firms to request a third-party, independent value appraisal as they prepare for a transaction.
EBITDA is often cited as the gold standard metric for value determination as it represents cash flow through the business. We have found that with some exceptions, larger and growing firms are generally valued higher from a Value to EBITDA ratio standpoint than smaller stable firms, because there is greater confidence in their financial forecasting. Indicating that as a firm grows, the relative value of the firm also grows. Conversely, from an Equity value to book value perspective, larger firms generally had lower multiples, because larger firms often carry more underlying assets and equity than smaller firms. The Value to backlog metric has trended down over the last 5 years, almost in line with the increasing trend in backlog through 2019. Value to backlog has somewhat stabilized over the last couple of years and crept up this year. it’s important to note that backlogs plummeted in relation to NSR in 2020. In previous years, backlog represented over 100 percent of the prior year’s NSR; however, in 2020 backlogs represented only 69 percent of the prior year’s NSR. It will be interesting to see how backlogs rebound when we get updated data in the summer of 2021.
Zweig Group’s 2021 Valuation Survey is intended to give firm leaders a baseline to explore the value of their firm or another firm during M&A negotiations. For the purpose of internal transition, the Z-Values and corresponding value calculations can be used in periods where a formal appraisal is not conducted. If you would like to learn more about your firms’ value this report is for you!