Valuing engineering firm stock 1

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.

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

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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.

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.

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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.