Valuation trends in the aggregates industry: which financial factors affect the value of an aggregates business? Understanding key value drivers for your company and prioritizing accordingly is the key to maximizing that value

Pit & Quarry, July, 2004 by Z. Eric Stephens

The financial markets are heating up. The stock market is flat, but bankers and venture capitalists are beginning to loosen their purse strings. Mergers and acquisitions (M&A) are also on the rise. As shown in Figure 1, M&A activity for mining companies (companies classified in SIC 1400-1499, which includes the aggregates industry) declined in 2003 following two years of growth. However, data through May 20, indicates that M&A activity for 2004 is on pace to exceed that of 2003.

[FIGURE 1 OMITTED]

In a July 2003 article, we introduced the concept of discounts and premiums in a valuation context. All else being equal, controlling interests (typically ownership interests of greater than 50 percent) are more valuable than minority interests (typically ownership interests of less than 50 percent).

Your 100 shares of stock in XYZ, a public company, represent a minority interest in that company. Thus, the stock price represents a minority interest value. If XYZ were to be acquired, a premium above the publicly traded minority interest price would likely be paid.

For the five years ended March 29, the median control premium paid for transactions involving companies in all industries was 28.0 percent, while the median control premium paid for mining companies was 30.0 percent.

Valuation trends

Following a strong 2003, the market has been flat so far this year. Through the middle of May, the Dow Jones Industrial Average (DJIA), which reflects 30 of the largest companies in the market, lost 3.4 percent; the S&P 500 Index, which contains 500 large cap stocks, lost 0.7 percent; and the NASDAQ Composite Index, considered a small cap index, lost 4.4 percent. Meanwhile, the aggregates industry, represented by the eight companies listed in the "Stock Watch" at the beginning of this publication, lost 1.6 percent.

The aggregates industry has outperformed compared to the S&P 500 Index and the S&P 500 Materials Index over the past several years.

The median price to earnings (P/E) ratio for the industry is currently 18.44. The S&P 500 has a P/E of 20.51 and the DJIA has a P/E of 18.84. The P/E of the NASDAQ Composite Index is not meaningful because it is reflective of many development stage companies with very low earnings.

In essence, the aggregates industry stocks are currently priced 2 percent lower than large cap stocks, as represented by the DJIA. The comparison to the DJIA is reasonable because the DJIA is comprised primarily of businesses in mature industries like the aggregates industry.

P/E is a widely recognized valuation multiple, but valuation professionals rely on other multiples as well. Figure 2 displays some of the popular valuation multiples for the group of aggregates companies listed in the "Stock Watch."

[FIGURE 2 OMITTED]

It is important to be aware of the range of pricing multiples in the industry. But how can you tell if a company deserves a multiple at the high end of the range or low end of the range? Generally, fast growing companies and companies with higher margins trade at higher multiples.

That gets you closer to an answer, but there is still some uncertainty. So, let's be more specific. What's the relationship between EBITDA margins (EBITDA/Revenue) and BEV/Revenue multiples?

A regression analysis can show the extent to which EBITDA margins explain or predict BEV/Revenue multiples for the aggregates companies listed in the "Stock Watch." A graphical depiction of such regression analysis is presented in Figure 4.

We determined that the relationship between the two variables is statistically significant. The regression equation set forth in Figure 3 had a coefficient of determination, R2, of 0.55, which means that 55 percent of the variance in BEV/Revenue multiples can be explained by EBITDA margins.

[FIGURE 3 OMITTED]

Furthermore, the t statistic associated with the EBITDA margin was 2.70. According to a commonly used rule of thumb, an explanatory variable is considered "statistically significant" when its t statistic is greater than 2.00. Thus, the EBITDA margin is a statistically significant variable in the regression equation.

This analysis is useful because it can assist a manager in estimating the value of his or her company based the company's sales and margins. One can eyeball Figure 3, but for greater precision, a manager should refer to the regression equation: y = mx b, where:

y = dependent variable (BEV/Revenue)

m = the slope of the line

x = independent variable (EBITDA margin)

b = intercept

Thus, if your company has EBITDA of $200,000 on $1,000,000 of revenue (20 percent EBITDA margin), you would expect your company's BEV to be approximately $1,750,000 (1.75 times $1,000,000). Basically, the equation predicts that for every additional $1.00 of revenue your company generates, BEV will increase by $1.75.

Now, let's look at another relationship. In a previous article, we discussed the importance of managing inventory. However, inventory is only one component of the trade cycle. A company's trade cycle is stated in terms of days (the number of days of receivables plus the number of days of inventory minus the number of days of payables). We know that a company's trade cycle should be minimized, but what is the precise impact on value?