Valuing engineering firm stock
Valuing engineering firm stock
(OP)
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...
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...
RE: Valuing engineering firm stock
Few companies can make "constant" profits over 30 years.
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RE: Valuing engineering firm stock
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.
RE: Valuing engineering firm stock
So if somebody were to buy the company, they would be buying current backlog under the existing contracts and nothing more.
RE: Valuing engineering firm stock
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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RE: Valuing engineering firm stock
RE: Valuing engineering firm stock
RE: Valuing engineering firm stock
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.
RE: Valuing engineering firm stock
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RE: Valuing engineering firm stock
RE: Valuing engineering firm stock
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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RE: Valuing engineering firm stock
RE: Valuing engineering firm stock
-> if you assume 10% chance of going bankrupt per year is conservative, PE of 5 is conservative too.
RE: Valuing engineering firm stock
RE: Valuing engineering firm stock
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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RE: Valuing engineering firm stock
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If you can't explain it to a six year old, you don't understand it yourself.
RE: Valuing engineering firm stock
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.
RE: Valuing engineering firm stock
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.
RE: Valuing engineering firm stock
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.
RE: Valuing engineering firm stock
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.
RE: Valuing engineering firm stock
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.
RE: Valuing engineering firm stock
The other rule of thumb I have heard is that a firm is valued at 1 years revenue.
RE: Valuing engineering firm stock
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.
RE: Valuing engineering firm stock
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.
RE: Valuing engineering firm stock
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.
RE: Valuing engineering firm stock
TTFN (ta ta for now)
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RE: Valuing engineering firm stock
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.
RE: Valuing engineering firm stock
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.
TTFN (ta ta for now)
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RE: Valuing engineering firm stock
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.
RE: Valuing engineering firm stock
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...
RE: Valuing engineering firm stock
RE: Valuing engineering firm stock
RE: Valuing engineering firm stock
RE: Valuing engineering firm stock
RE: Valuing engineering firm stock
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.
RE: Valuing engineering firm stock
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.
RE: Valuing engineering firm stock
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.
RE: Valuing engineering firm stock
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.
RE: Valuing engineering firm stock
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.