French philosopher Étienne Gilson once wrote, “History is the only laboratory we have in which to test the consequences of thought.” Gilson’s statement is wise, and yet, few people would argue that history provides a road map for the future since each experience is subject to an infinite set of variables, virtually guaranteeing its unique outcome. Nevertheless, studying history provides a better understanding of the relationships between variables and ­outcomes.

This article explores how specific economic indicators, episodic events, and financial metrics have influenced the historical value of publicly traded engineering and construction (E&C) companies. In addition, the article examines the correlation between the general stock market and the market for E&C companies. Examining these relationships makes apparent the influences driving the value of individual companies within the industry as well as the industry as a whole.

For this analysis, publicly traded E&C companies in the study were segmented into four groups:

• Architectural, engineering, and environmental consulting firms (“A/Es”)
• Construction contractors (“contractors”)
• Basic construction materials suppliers [construction aggregates, cement, and asphaltic and cement-based concrete] (“materials”)
• Residential homebuilders (“homebuilders”)

Five of the E&C firms (Fluor, Foster Wheeler, Hill International, Jacobs Engineering, and The Shaw Group) were included in both the A/E and contractor groups since they have major operations in both aspects of the industry and are heavily involved in design/build services. Similarly, Centex was included in both the contractor and residential homebuilding categories.

For better comparative analysis, the contractor group was further divided into three subgroups with common types of construction activities:

• General commercial and industrial construction (“general”)
• Heavy civil, highway, and infrastructure construction (“heavy/highway”)
• Specialty contractors, such as electrical, mechanical, telecom, drilling, and structural steel construction (“specialty”)

Studying the recent, overall E&C market performance offers insight into how specific factors affect the value of these E&C companies. As measured by growth in gross domestic product (GDP) over the past ten years, the U.S. economy has been remarkably strong and stable. Quarterly GDP figures, based on seasonally adjusted annual rates, from the second quarter of 1997 through the second quarter of 2007 has steadily risen, climbing at an average annual rate of 5.3 percent. The E&C industry has benefited from this economic expansion, as the total amount of construction put in place has risen from approximately $648 billon in June 1997 to more than $1.1 trillion in June 2007, an average annual increase of more than 6.1 percent.

In other words, the E&C industry has been expanding at an even faster rate than the overall economy over the past ten years, with construction put in place climbing from 7.9 percent of GDP in June 1997 to more than 8.5 percent of GDP in June 2007.  

E&C companies have thrived under these conditions. The E&C industry has significantly outperformed the S&P 500 over the past ten years. Between July 1997 and June 2007, $1,000 invested in the S&P 500 would have returned $1,698 (a 5.4 percent annual return); whereas, that same $1,000 would have returned $3,629 (13.8 percent annual return), $3,968 (14.8 percent annual return), or $6,958 (21.4 percent annual return), if invested in engineering and architectural firms/contractors, basic construction materials companies, or residential homebuilders, respectively, during the same period.

E&C companies have also benefited from a widespread expansion in valuation multiples. In comparison to historic norms, each of the E&C groups, with the exception of residential homebuilders, is currently trading at exceptionally high multiples. For example, on June 30, 2007, the median total enterprise value (TEV)/Revenue multiple for publicly traded general contractors was 0.98x, which means that investors were willing to pay $0.98 for every $1 of revenue generated by a general contractor.

Over the past decade, investors, on the median, have only been willing to pay $0.54 for every $1 of revenue generated by a publicly traded general contractor. On the surface, this difference may seem inconsequential. However, consider that over the most recent trailing 12-month period, the average revenue of the general contractors included in our study was over $6.8 billion — the difference becomes staggering. Applying the math, a $6.8 billion contractor valued at 0.98x revenue would have a TEV of roughly $6.7 billion, whereas that same contractor valued at 0.54x revenue would have a TEV of roughly $3.7 billion, equating to a valuation difference of $3 billion.

Since continued multiple expansion is highly improbable (i.e., investors will only pay so much for a dollar of revenue or a dollar of earnings), in the near term, the value of E&C companies is more likely to be driven by the strength of the construction market and the overall economy. In fact, some industry observers might argue that an industry trading at the upper end of its valuation range is likely to be hypersensitive to a weakening of its economic environment.

A dramatic example would be the dot-com bust. In the late 1990s, technology firms were trading at outrageous revenue and earnings multiples. Yet, once the exuberance faded and the economic environment began to turn, valuation multiples of technology firms were quickly depressed. While the E&C industry will likely never be subject to the same sort of irrational exuberance, if the current economic environment significantly deteriorated, valuation multiples of E&C firms could fall to much lower levels. Consequently, it is prudent to take an entire set of circumstances into ­consideration.

The remainder of this article presents the individual economic factors, financial metrics, and episodic events that influenced the historical value of publicly traded E&C companies.      

For the ten-year period beginning July 1, 2007, and ending June 30, 2007, FMI contrasted quarterly changes in the total enterprise value (TEV)1 of publicly traded E&C companies against a series of economic indicators, including changes in GDP, changes in interest rates, and changes in the total amount of construction put in place.

Each group’s TEV correlated positively with GDP and the amount of construction put in place in the United States. However, the degree of correlation varied substantially between the groups.

Residential homebuilders exhibited the highest degree of correlation to these economic indicators, suggesting that homebuilders are particularly sensitive to the health of the overall economy as well as fluctuations in the construction cycle.

Specifically, analysis of the relationship between TEV of homebuilders and GDP revealed a median correlation coefficient2 of 0.89. A correlation coefficient of this magnitude suggests that approximately 80 percent of the variance in homebuilders’ enterprise values can be explained by changes in GDP. Analysis uncovered an even stronger relationship between the TEV of homebuilders and the amount of total residential construction put in place.

In comparison to other E&C companies, changes in the economic environment had little effect on the TEV of specialty contractors. A weak relationship between these variables suggests that, over the period examined, changes in the value of specialty contractors were relatively independent from changes in the economy. With the exception of residential homebuilders, the TEV of E&C companies did not correlate strongly with changes in interest rates. So fluctuations in interest rates do not materially influence the value of non-homebuilding E&C companies. Analysis uncovered a relatively strong inverse relationship between mortgage rates and the value of residential homebuilders, suggesting that homebuilders will benefit when interest rates decrease and suffer when interest rates increase.

To determine how much the overall stock market influences E&C stocks, FMI contrasted the quarterly share prices of each publicly traded E&C company with the S&P500 and the Dow Jones Industrial Average (DJIA) from June 30, 1997, to June 30, 2007. Each of the E&C groups exhibited a higher degree of correlation with the DJIA than with the S&P500.

Yet, fluctuations in these indices explained only a small amount of movement in the share prices of E&C companies. For example, the basic construction-materials group exhibited the highest degree of correlation with the DJIA; however, only 44 percent of the quarterly change in the share prices could be explained through changes in the DJIA. Thus, the E&C industry moves relatively independently from the stock market as a whole.  

In order to determine the financial metrics that have had the greatest influence on the value of publicly traded E&C firms over the past 10 years, FMI studied the relationship between the following sets of variables: TEV/Revenue, TEV/EBITDA (earnings before interest, taxes, depreciation, and amortization), TEV/EBIT (earnings before interest and taxes), Price/Net Income, and Price/Book Value (P/BV). Analysis revealed that changes in revenue were highly correlated with changes in TEV, and changes in share price were highly correlated with changes in book value. This suggests that changes in an E&C company’s revenue base and book value influence the valuation of the company to a greater degree than changes in ­earnings.

A number of reasons explain why the financial markets rely heavily on book value and revenue in determining the market value of E&C companies.

First, P/BV is widely regarded as a good metric to value stocks of companies in capital-intensive industries, such as E&C, which have a large amount of tangible assets on their books.

Second, P/BV provides an indication of the inherent value of a company and, as such, can be used as a proxy for the price that investors are willing to pay for a company experiencing negligible growth. Since E&C is a relatively slow-growth industry, analysts consider P/BV to be a reliable measure of valuation. Price/BVs dependability as a measure of valuation is further enhanced by the low utilization of debt in the typical capital structure of an E&C company. This is ­because low debt levels do not marginalize a company’s asset base.

Third, in highly cyclical and competitive industries, such as E&C, earnings are commonly subject to a higher degree of variance than revenue. Accordingly, revenue growth is weighted heavier than earnings in the determination of value.

Lastly, earnings figures rely heavily on accounting estimates, which can be manipulated to inflate or deflate earnings. As a consequence, analysts often view revenue as a more reliable measure of performance than earnings.

Out of the three earnings measures analyzed by FMI, EBITDA consistently exhibited the highest degree of correlation with TEV. Such consistency suggests that the financial markets rely heavily upon EBITDA, contrasted with EBIT or net income, in determining the value of E&C companies. This finding agrees with EBITDA’s increased use as an indicator of profitability throughout the financial community. Most investment professionals consider EBITDA to be a cleaner measure of income generation since it is not subject to the vagaries of depreciation methodologies and nonoperating financial income and expense charges.

Finally, FMI studied two different types of episodic events expected to influence the share prices of E&C companies. Specifically, FMI studied data on acquisitions and stock buybacks involving publicly traded E&C companies in order to determine the degree of impact that these activities have on a company’s share price. FMI studied only acquisitions with transaction values greater than $100 million that were made by publicly traded E&C companies between June 30, 1997, and June 30, 2007. Additionally, transactions were considered only if they represented more than two percent of an acquiring firm’s revenue base at the time of acquisition.

In order to determine the relative effect of the acquisition, the acquiring firm’s share price was measured at different intervals before and after the transaction closing date. Changes in the acquiring firm’s share price were then contrasted against the average change in share price of the most comparable ­segment of the E&C market. The resulting differences in share price provide an indication of the effect acquisitions have on the equity value of an acquirer. FMI segmented the results into six different categories to illustrate the effect of transaction size.

Small transactions had a relatively minor impact on the share prices of acquirers, while large transactions tended to result in share-price gains immediately before and after a transaction closing date. One year after the close of a major transaction, the acquiring firm’s share prices tended to trail that of its respective peer groups. However, it is difficult to determine whether this phenomenon was a result of the acquisition, or if it was due to factors completely independent of this analysis.

Using this same approach, FMI analyzed the effect of stock buybacks on the share prices of E&C companies. FMI gathered information on stock buybacks made by publicly traded E&C companies between June 30, 1997, and June 30, 2007. Only buybacks greater than $25 million were considered.

The results of the analysis were not segmented by size, due to the limited number of data points available. Furthermore, residential homebuilders represented a highly disproportionate number of the buybacks studied, making the results of the analysis most applicable to this particular segment of the E&C industry.

The study did not find a substantial effect on the share prices of E&C companies that bought back a sizeable portion of their shares. So, on a short-term basis, stock buybacks do not significantly influence the value of E&C companies. The lack of effect also suggests that management generally does not possess greater insight than the overall market as to when their shares are undervalued.

Analysis did show a modest two percent difference one year after the buyback between the buyback companies and their peers.

History undoubtedly provides some insight into factors that drive the value of E&C companies; however, the interaction between infinite numbers of variables limits our ability to predict the future through past events. While the quantitative nature of the factors discussed lends itself to analysis, another more qualitative set of factors could have an even greater impact on the value of E&C companies. Qualities such as leadership, vision, reputation, organizational depth and breadth, and the ability to attract and retain talent are undeniably critical value drivers as well.

In highly competitive industries, such as E&C, these qualities may be even more important than many of the quantitative factors. In short, the future value of E&C companies will be driven by the measurable, the immeasurable, and the unknown. SLDT