Valuing engineering firm stock 1

[glass99]

I recently realized that the value of a firm's stock is simply equal to the Present Value of its future profit. If you assume a constant rate of profit and a risk and inflation weighted interest rate and a time horizon of say 30 years, you get some pretty sane results. Its the world's simplest formula:
PV = Profit(1-(1+r)^-n) /r.

Does anyone have any experience with this? Obviously you can make it a lot more complicated but maybe we shouldn't...

 

[glass99]

AECOM buys many 500 person firms a year, which is how they got to be 87,000. It was NOT by organic growth. They have a stock market valuation of $5BB which is arguably $3BB taken from the pockets of firm founders over a period of the last 20 or so years. They do add a layer of expensive bureaucracy which reduces earnings, so a higher multiple is necessary, but the tripling of PE remains a curious effect to me.

A 500 person firm is pretty machine like, and not reliant on a couple of founders usually. We are talking storied firms here like DMJM Harris that are now part of the AECOM borg.

 

[Retrograde]

For small firms, there is a rule of thumb that is often used. I think it is a firm is valuated at 3-5 their yearly profits.

The other rule of thumb I have heard is that a firm is valued at 1 years revenue.

 

[CWB1]

I've worked mostly for large corporations on large scale projects so a few hundred engineers to me is commonplace. I've had projects where several dozen reported to me and spent a few years in an office that had 300 engineers in a single large open "room"/cube maze. Even at that size its still pretty common that the majority rely on the decisions of a handful of decision makers.

Regardless of the size distinction between "small" and "large" companies, large companies do enjoy a lot of advantages over small ones which increases their chances of long term survival during downturns, which is ultimately what matters most to potential buyers considering P/E ratios. A conglomerate of tiny firms will have potential for much greater savings based on economies of scale, not only in purchasing but also in terms of efficiency with supporting admin/hr/marketing/other business-y roles. Size also enables a lot of business, at my last two small employers I often wished I had a previous mega-corp employer's name behind me when dealing with suppliers and potential customers, until someone has worked in both worlds its difficult to imagine the doors closed and profit lost. With size also stereotypically comes diversification of products/services and markets, which can be key to weathering the aforementioned downturns. More than once I've worked at large plants that operated at a loss for months on end, literally thousands of employees losing money yet the company and plant survived due to profit earned by others whom I'm sure endured their own downturns which we covered. Tit for tat. Taken to the extreme, companies that are "too big to fail" are a helluva lot more appealing to buyers than similar but small companies so command a higher P/E ratio as the chances of a buyer getting his money back are greater with the larger company.

 

[glass99]

Retrograde: Valuation at 1 years revenue would imply a PE of 10 if you had 10% profit (which actually sounds kind of reasonable to me).

CWB1: The operational utility of big vs small is a larger discussion, but in the construction world there are not a lot of economies of scale to be had. Its actually a matter of dis-economies of scale and being forced to be big just to take on a large airport or something. A 200 person local office just gets bolted on to the 80,000 person organization as an independent entity with the added expense of more management. Boeing or Facebook probably have different logic.

 

[StrucPEng]

I would say (without much evidence I must admit) that a profit margin of 10% in this industry is rare, AECOM as an example (not a good one) has a profit margin of 0.68%. I will sympathies with the point about conglomeration of the economy being distasteful and potentially dangerous but that is probably a separate discussion in itself. With that said, I think the point CWB1 makes is probably closer to the truth. Yes AECOM could be seen as being bloated with too much bureaucracy and policies, and paper pushing departments but that is what makes a company of 87,000 people function well. That is also where you gain your economy of scale since each 500 person subsidiary does not need a receptionist, HR manager, accountant, lawyer, etc. they can just have engineers, architects and PMs. The size of the company also is what makes it possible to get jobs, the reality is a municipality, federal government organization or fortune 500 company does not want to trust the design and construction of their new building/road/sewers to a 200 person firm that has maybe done one project of that scale when they can have AECOM do it. AECOM can also bring everything under one roof which is a significant savings (and helps the overall bottom line), they can handle the engineering, architectural, project/construction management, design of the utilities, probably even landscaping and facility management once its built. They can also finance these projects and bond for the large projects where small firms can not.

I agree there is a discrepancy in the small firm vs. large firm valuations but its similar to baseball player salaries. You can have a 5-tool baseball player who makes $20M/year and on the same team have a 2-tool player who has a higher batting average than the 5-tool player but makes $3M/year. Yes he can do the same thing in the batting department and by all accounts should be rewarded for that commensurate with the 5-tool player but the full package is worth more than then individual parts in some regard.

 

[IRstuff]

Another advantage of a large company is the ability to "outsource" internally, i.e., if a small group has too little or too much work, some other small group might have the opposite problem and the resources (bodies) can be borrowed and shared. This works particularly well if the "skills mix" is similar across the groups, and the large the corporation, the more likely it is that there is a comparable group with comparable skills mix.

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[glass99]

I did not invent the dis-economies of scale in construction professional services idea:

https://hub.hku.hk/bitstream/10722/195924/1/Content.pdf?accept=1

Even if there are economies of scale, they are modest, and definitely do not justify a tripling of PE.

 

[IRstuff]

I don't think anyone is claiming that, particularly given the razor thin margins. But, the economies of scale is probably helping the margins enough to make it worthwhile to merge; you beat the G&A people into working more efficiently to handle much higher workload. The main benefit of merging is some level of survival should a major customer or contract tank; that doesn't always work out, but Uber certainly didn't tank when they dumped their entire Arizona self-driving group and few survived that particular bloodbath. But, the group as a whole seriously messed up, and it's pretty clear from the data that's been shown that the AI architecture was woefully unprepared for any moving obstacles, so a lot of good people were dumped because the system architects simply didn't understand some basic concepts about moving targets.

The bottom line is that a merged company can do a better job of managing potential and realized risks; our division, while not necessarily bringing in its own business, has survived by helping out other divisions in the corporation manage their own workloads and skills mixes. Obviously, the poor performance of our own marketing would have otherwise tanked us had we been on our own, but we're smarter than the average engineering bear and have kept other divisions out of hot water and we're surviving pretty well.

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[StrucPEng]

I don't believe that paper does much for the argument, granted I did not read the entire paper word for word. It does seem to imply that there are clear economies of scale that are being achieved through M&A and lays out multiple examples (that have been mirrored here) and then goes on to suggest there are possible dis-economies but docent allude to where they would arise other than the argument that the companies need to focus on local issues (I.E. site specific work) while maintaining an international company architecture.

While the economies of scale may be minimal in CPS companies and not warrant such an increase in P/E, you also have to consider the increased pool of potential clients (total addressable market), the growth opportunities (countries that they can do business in, if the Middle East is building big time AECOM can take advantage of that growth with offices there, a small firm in Massachusetts can not). This is why Amazon has the valuation it does, they sell everything to everyone (huge market).

You also have overall stability like IRstuff points out. The company can weather economic storms, it can use its size to gain contracts, it has an economic moat that other companies can not compete with. Stability in the world of investing is a valuable commodity. No large pension fund or asset manager wants to risk their money when they don't have to so a company with growth (organic or otherwise) and a moat to keep other companies at bay has lots of value. Smaller firms that could go belly up or ones that are much less prestigious when the partner with his name on the door retires just are not worth the same as a titan of industry. Sad world maybe but the world none the less.

I wouldn't say the companies that are selling for 3-5 times earnings are being fleeced if that is the deal they want to make in order to retire or get wealthy or whatever reason. You need a willing buyer and a willing seller to make a market.

 

[glass99]

The other datapoint in the dis-economies of scale idea is that large firms charge more per hour for the same level of engineer than a smaller firm. For example a 10 year senior structural engineer, a large firm will charge approx $175 whereas a small firm will charge $125. The difference has always been explained to me as being the higher overhead of the large firm. Large firms also make less percentage profit than small firms. These are opposite outcomes to what you would see in classic economies of scale industries like auto manufacturing.

If pre-IPO engineering firms only trade at lower PE's than their publicly listed counterparts because of the lack of a willing buyer rather than something fundamental, it does create the mother of all arbitrage opportunities for someone. Let's imagine that someone is on of the private equity firms or holding companies currently prowling through our space...

 

[StrucPEng]

I think the fundamental items we have discussed before (project size, region diversity, etc.) contribute to the lower P/E ratios but I see your point on the arbitrage. I guess i would say to that, we don't need P/E firms or holding companies to prowl looking for a deal, the AECOM's of the world are doing that already. They have the experience in the industry and they buy smaller firms that are strategic assets to them at a price that I assume they are happy to pay so that is the arbitrage in a sense. They pay a lower multiple to increase their stock price at a proportionally larger multiple.

 

[glass99]

The upside to all the AECOM (et al) prowling is that it provides an exit strategy for retiring founders other than just management buyout. I just want founders and owners to have a bit more backbone and/or chutzpah really.

 

[StrucPEng]

Yea a management buyout is usually a pretty poor exit strategy, and I get what you are saying and I would want any founder to get the best deal they can given the work they put into building the business. I have noticed, and this is anecdotal, that when it comes to engineering it seems like the business side/sense can be generally lacking in may smaller firms. They can be really good at design, drafting, and even retaining clients but the business acumen is not there sometimes. This is probably not exclusive to engineering but to most businesses, probably why so many fail as we discussed earlier.

 

[glass99]

Yes lack of business acumen in consulting engineering is definitely a problem. People go into it because they want to design bridges, not haggle about money. Interestingly, its also a problem in law firms. Lawyers go into it bc they like debate and literature.

 

[HamburgerHelper]

Glass99,

It isn't just engineering that is like that. A lot of food items like wine are like that. If you want to make a lot of money making wine, you have to focus on distribution. You make a lot less per bottle selling to a distributor than selling on site but you are not as limited. A farmer is going to get a lot more selling direct but that quickly becomes unmanageable.

Big firms sometimes offer something that small firms can't. No one but big firms can do billion dollar projects. There are not that many companies that can put together the staff for huge projects.

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If you can't explain it to a six year old, you don't understand it yourself.

 

[glass99]

Hamburger: Yes I could imagine an artisanal wine maker being frustrated by commercial reality in the same way that engineering designers are. But I still believe that people capable of doing both are the Chosen Ones.

Big firms can indeed do billion dollar projects where small ones can't, and there are actual significant economies of scale on the construction side of the project.

 

[CWB1]

The other datapoint in the dis-economies of scale idea is that large firms charge more per hour for the same level of engineer than a smaller firm. For example a 10 year senior structural engineer, a large firm will charge approx $175 whereas a small firm will charge $125.

Interesting difference between industries. IME on the product development side, small firms usually cant compete with larger ones on labor rates, and quite often the large engineering service firms' rates cut below OEs' internal rates on long-term contracts. The later is a bit of a sore subject for many but the service firms business tends to be a bit more steady than any single OE's as they're usually working across multiple industries and companies (read: somebody always has money to spend), and they're large enough to get the equivalent economies of scale as the OEs but usually don't have half the R&D or other infrastructure investments. The upside is that OEs save on labor, the downside is that coordinating outside firms creates many headaches for OE engineers and erodes away at their job security as the business folks notice dollars and cents and push for savings today at the expense of an expensive cluster tomorrow.

 

[HamburgerHelper]

Glass99,

Everything goes out the window when anything gets too many people involved and things get too complex. In the game Railroad Tycoon 2, it is infinitely easier to run a small railroad with high profits and margins than a large railroad with more risk and smaller margins. I know that is just a railroad simulator but the bigger something is, the more risk their is to mismanagement. Dentist are one of the highest paid people on a per hour basis in the medical industry because they stay small and manage their own office.


Two of my favorite rules for business structure and management are:

The Zen of Python - in my opinion principles of good programming apply to a lot of other things. Structured programming and business structure to me have a lot of similarities.

Kelly Johnson's 14 rules - Kelly Johnson was a great engineer at Skunkworks but I think his real gift was management. Tight, smart, and small teams can do things large teams can't.






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If you can't explain it to a six year old, you don't understand it yourself.

 

[glass99]

HamburgerHelper: Yes and Yes! Kelly Johnson and SkunkWorks still remain to me the high water mark of engineering practice. Small, smart, brave and tight.

CWB1: I imagine your large product development firm is achieving lower hourly rates by using offshore labor, not by operational efficiency. The only operational advantages I know of for large firms are cheaper health insurance and cheaper software - significant savings but also limited. Everything else is more expensive, particularly all the HR bureaucrats, but also office space in the fancy part of town. Its more about the need for a large team to do a large project. You can't design a 747 with 5 guys.