First in a two-part series
You can't chat with a group of builders today without hearing about slowing sales, and the industry is anticipating a prolonged period of softer market conditions. This two-part series will explore the impact of valuations on home-building companies.
In this article, we debunk valuation myths and discuss how a softer market affects valuations. In Part 2, we'll detail valuation methodologies.
Our valuation methodology builds on three premises:
- A company is worth what a prudent buyer will pay in today's business environment.
- Public companies will not close deals that are dilutive to their current or future earnings per share.
- No one can buy historic performance.
The first two assumptions are better understood than the third. Although builders believe their company will be valued on past performance, our valuations are based on future performance, particularly the next 12 months. Performance can be proven from the backlog and lot inventory and can affect an acquirer's financial performance in the short term. The builder's history adds credibility to the projections. We will discuss valuation methodologies more in depth in the next issue.
The Myth of Book Value
We typically use three pricing models to frame a range of value, calculating additional financial ratios used by the acquirers as a cross-check. We then apply subjective criteria to narrow the range.
A common myth is that book value is the key to establishing value. Nearly every builder knows someone who reportedly sold a company for a high multiple of book value. In fact, our models utilize future after-tax income and future EBITDA (earnings before interest, taxes, depreciation and amortization) after the effects of purchase accounting. We calculate the multiple of book value after the valuation has been established. Because the full details of an acquisition are rarely reported, the apparent multiples are in the stratosphere.
Transactions closed in the last four to five years often had significant cash paid at closing, mistakenly assumed to be outrageous premiums that added to the multiples hype. In reality, buyers were flush with cash and their credit lines nearly untouched. With fairly predictable income streams available for purchase, they preferred to acquire a builder's future profits up front and pay less overall than pay out over time based on actual long-term performance.
What Is Changing
Future income projections are now less reliable, and the public builders have been under pressure from Wall Street to use cash to buy back stock. Buyers now prefer to pay for future earnings based on actual performance and will pay less at closing yet potentially more overall for their acquisitions. Sellers can expect scrutiny of their projections with a conservative eye, particularly a year out when the backlog from year-end 2005 is gone and replaced by fewer sales at lower margins.
The current softening of land/lot acquisition terms should be followed by softer pricing if history is an indicator, which could impact values for those builders with significant land inventories. The next wave of transactions will probably look more like those we constructed in the early 90s, with earn-outs that reward sellers handsomely for meeting or exceeding projections. Most if not all of our sellers did very well for themselves via earn-outs that had varying degrees of riskiness.
Jody Kahn Kline develops marketing materials for MPKA's seller clients as well as heads many assignments in which MPKA represents buyers. She provides market research support and identifies and screens prospects.