Sure, the basic issue, of course, is that no one can sanely predict a company's profit beyond a 6 month horizon, if even that. I'm still waiting for Yahoo to make the profits predicted in 2001. And, of course, there are literally thousands of companies that never made it much past their IPO. Eagle Computers founder bought a Ferrari and crashed and died that the day of its IPO, and the company teetered and tottered for another 3 years, for other reasons, as well.

Few companies can make "constant" profits over 30 years.

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I spent a few years getting my Chartered Financial Analyst credential when I had engineering burnout after university. While you are right, generally a simple business is worth the present value of all future free cash and you can get some fairly reasonable valuations that way, there are many variables and assumptions that in reality complicate the calculations.

Getting the inflation, risk assumptions correct is complicated in itself and can change the value quite a bit. You then ideally would have to look at future opportunities of the business, what is their ability to grow their addressable market, what does that do to costs (fixed and variable) what is the value of the service that they offer (is it a tangible good or a service), how does that fit in with the broader economy. I just read in another thread where someone made a point in regards to engineering firms specifically that they are only as valuable as their talent. They don't have many assets and only make money if they can provide valuable service to the clients, that would mean at any time their stock value could change a lot if a few key players retire or clients jump ship.

If you are using this calculation to value your stock purchases or stock offer from your company then I would be cautious of simplifying it as you have above. There are whole industries that do valuation for a living (hedge funds, investment banks, pension funds) and they only get it right 50% of the time. On the other hand if you are doing it for "fun" and you want to learn more about it, I would recommend looking up Aswath Damodaran. He is a professor at NYU and known as the "Dean of valuation". He has a site where you can download excel spreadsheets to value companies as well as a fantastic youtube channel where he teaches all the details of company valuation in a really understandable way.

you should limit your valuation to something far less than 30 years. Value is usually limited to work under signed contracts. It depends on the business model, but backlog can not be accurately predicted much more than 6 months into the future. Most contracts are short, less than a year. Most business is heavily dependent on the overall economy which can change every political cycle (local and national) which is probably two years

So if somebody were to buy the company, they would be buying current backlog under the existing contracts and nothing more.

Quote:

I recently realized that the value of a firm's stock is simply equal to the Present Value of its future profit.

Well not really.

The value of a firm is what someone will pay for it.

Figuring out what someone will pay for it, short of putting the firm on the market, is a task usually performed by comparing what other similar firms "out there" were recently valued at....not unlike how home valuations are developed.

There is also the issue of valuing the firm for
A) ...strictly internal purposes (valuing shares for trading between parties inside the firm), and
B) ...for external purposes (what would a larger engineering firm pay for our company if they bought us out)

In the several firms I've worked for, the A) valuation has usually taken the form of a sort of book value - looking at accounts receivable as well as the last three or four years of revenue to arrive at a number. There are all sorts of ways to set this value and your original post forumla could be one but not one going out 30 years.

For the B) valuation - this would also include what is generally referred to as "goodwill". A valuation much higher than the internal "book" value and includes the firm's good name/reputation, ability to generate revenue, market forces (supply and demand of similar firms), etc.

The B) value also would vary depending on the agreement of the purchase relative to current key employees. An engineering firm value is significantly based on the value of the key personnel. Thus you get purchases where the original owner's and original key personnel are required under contract to stay with the firm some minimum number of years...say 3 to 5...to allow a smooth transition and not lose clients and business due to an immediate exodus of engineers.

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Read the other current thread, "Engineering Firm Financials". It's more or less the same thing that is being discussed here.

Value = assets + projected profit. The later is often the critical element in small business as it varies greatly by buyer.

cwb1 + IRstuff: yes 6 months out is all you know for sure, but stocks are about probabilities not certainties. Probably you are going to have a project next year and the year after, but you might not.

In my experience people tend to dramatically undervalue smaller engineering firms bc of the "I don't know" factor, forcing retiring partners to leave millions of dollars on the table. We are addicted to certainty. My point in making it simple is that it allows rationality to shine some light into the darkness.

At the root of an evaluation, particularly for a small company, is not just the probabilities, but also the risks. In a large company, losing one or more engineers to death, illness, or jumping ship might not affect future earnings that much. Losing a principal, or a large contract, in small company could spell disaster, or not; that's what winds up "undervaluing" that company. It's the same kind of reasoning that "stated income" is less desirable in the home and personal loan business.

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I think the point JAE made is the most important, the firm is only worth what someone is willing to pay for it. Valuing the firm simply with the assumption that it will be a going concern and continue to grow profits is a nice notion but not the reality. 30% of small businesses fail in the first 2 years and that rate increases to 70% after 10 years. Like IRstuff said, they are heavily reliant on the talent at the company and the contracts/clients they can secure and maintain. That "money on the table" is the risk premimum that the purchasers recieve if the company succeeds. By selling out of the company you are also transferring your risk that the business fails and that has a cost to it and in some cases it can be a lot. Engineering firms are most likely worse than other businesses since they are tied primarily to the economy (building, manufacturing) and are pretty cyclical in terms of revenue.

Note that the P/E ratio essentially encompasses the FV of the earnings already, and yet, P/E ratios can be completely off the charts or even infinite, depending on the level of risk, market segment, market sentiment, yadda, yadda, yadda. There was a time that Yahoo was valued at something like 400 P/E ratio, while others had valuations but no earnings, so P/zero = infinite. The market is only theoretically about rational behavior; yet Greenspan pointed out "irrational exuberance" during the heady days of the internet stock explosion.

And this is nothing new; the infamous tulip bubble of the 17th century valued single tulip bulbs at multiples of the annual salary of a skilled crafts worker.

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IRStuff: the question is what should the PE ratio be. A publicly listed engineering firm like AECOM has a PE ratio of ~12-20 but a typical ESOP or management buyout usually assumes 3-5. Its a pretty gigantic arbitrage opportunity, and can unnecessarily lead to smaller firms becoming part of a publicly listed bureaucracy.

It also occurred to me that if you have a high interest rate in the formula (effectively high risk) that the value of n doesn't matter much because it heavily discounts future profit, and limits your PE to about 5 at a rate of 15% for any reasonable time horizon. This is basically saying the firm has a 10% chance of going bankrupt every year.
-> if you assume 10% chance of going bankrupt per year is conservative, PE of 5 is conservative too.

Glass: I think you're hitting on a pretty good conclusion with your 15% discount rate. When it comes to private company valuation there are may other factors that come into play when you value the company that can cause a disparity in the P/E compared to a public company. You would have all your normal concerns, inflation, risk, return expectations. You would also have due diligence costs to recover, most of these private deals are funded by debt so you have to account for paying that off in your return estimates, the illiquidity premium alone can cause a large reduction in the value (you cant just call up your bank and sell a private engineering firm to the next guy).

" the question is what should the PE ratio be"

OK, now we're getting into the realm of "does this dress make me look fat?" If you watch "Shark Tank" at all, you'll note that they don't even bother with P/E ratios much above 1; the P/E ratio should be whatever "people" are willing to pay, as mentioned by others here. You're looking for an engineering answer to an non-technical problem.

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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.

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IRStuff: you can always just assume its worth nothing, but I guess the point I am making is there IS some logic to it. For example, most places I have worked I could confidently say that it would survive for at least the next three years with no more than a 33% chance of going bankrupt. These are established businesses, not shark tank "ideas". Therefore the PE would be at least 3 * 2/3 = 2. But that seems very conservative, and these places have survived for 50+ years with strong on-going operations.

StrucPeng: yes liquidity and the depth of the market is important for small firms

Another interesting aspect is the value of the goodwill. A fancy french firm in my area of practice called RFR was bought out from bankruptcy but a publicly listed firm called Artelia basically bc of its archive of posh projects. The Peter Rice glow lets call it. I think the value of its on-going operations was small but they were this legendary practice which fell on hard times.

Quote:

the question is what should the PE ratio be. A publicly listed engineering firm like AECOM has a PE ratio of ~12-20 but a typical ESOP or management buyout usually assumes 3-5.

Value typically varies with size of the company as noted above, but <500 person small businesses are usually considered a fair deal at ~3-5x + assets and larger companies ~10x due to the higher likelihood of their weathering business downturns. Tiny businesses with <10 employees OTOH quite often have no saleable value as reputation commonly cant be separated between the owner and business itself.

CWB1 - Yes! So if 70,000 person AECOM buys another 500 person firm at a PE of 4 and convert it to a PE of 12 simply by virtue of being larger, you now know why they exist at all.

It raises the important question of really should we allow AECOM to screw us like this. Why is the market for 500 person firm's stock so weak? At the scale of people working in them or owning them, its a lot of money. No one on Wall St really cares bc its a rounding error for them.

That is not really how it works though. Just by buying the smaller company at a 4 P/E does no then make it a 12 P/E once it is part of AECOM. Investors are paying $12 for $1 of earnings generated by AECOM that is essentially what a P/E ratio measures. It would be arguable that a 500 person engineering firms earnings would be a rounding error in comparison to AECOM ($18 Billion (2017) with 87,000 employees). That purchase would increase their staff by 0.5% and probably their revenue proportionally. The 8 P/E delta between the two companies can account for the infrastructure the assets, the market clout.

I see what you are trying to get at, that the small firms are being taken advantage of with low multiples and undervalued purchase prices but an investor would be much more willing to pay a 12 P/E for a titan like AECOM which has offices on every continent and in every state in America, its own financing divisions and ability to bond and work on almost any project in the world than pay that multiple for a <500 person firm that does work only in one region and is reliant on a few principles to drum up business.

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.

Quote (HamburgerHelper)

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.

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.

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.

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.

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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I did not invent the dis-economies of scale in construction professional services idea:
https://hub.hku.hk/bitstream/10722/195924/1/Conten...

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

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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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.

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...

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.

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.

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.

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.

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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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.

Quote:

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.

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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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.