Business Valuation Sites on the Web
Valuators must use a broad picture approach. Taking the Temperature of Health Care Valuations BY LOREN GARRUTO AND OLIVER LOUD
WHAT PROMPTS AN INDEPENDENT VALUATION? Throughout a company’s lifecycle, certain events or business necessities—such as ownership transition, compliance and strategic planning—may require an independent appraisal of its capital structure. Typically, the business owner’s goal is to integrate strategic and financial plans and optimize investments. Companies seek valuation experts to obtain independent opinions of their value, the fairness of certain transactions and the implications of strategic business decisions, such as discontinuing a product line, selling a division or acquiring a competitor. Management also may seek to better understand how its business value is allocated across different business segments and the key determinants, or “drivers,” of value. Thus a valuation can provide insight into which segments of the business create larger portions of value within the total operation, which segments are weak or should be divested and whether other segments should be acquired to enhance profitability. Sometimes the law requires independent valuations. The IRS mandates them for gift and estate tax purposes, such as gifting of shares in a privately held company by the owner to relatives. The Department of Labor requires them for qualified retirement plans, such as employee stock ownership plans, at the time of installation of the plan and then for annual updates. Bankruptcy is yet another situation in which independent valuation work is needed. PICK THE RIGHT VALUATION APPROACH
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In many situations the law or contracts mandate the standard of value for the valuation; sometimes, the parties involved in the transaction stipulate the standard. In a health care valuation, valuators weigh basic operating characteristics: the services provided, how services are reimbursed, patient referral sources, service area covered, regulatory compliance, cost containment and utilization management. They ask the client to provide pertinent information to estimate the value of the provider or its underlying assets (see “Get the Right Data,”below) and then choose one of three traditional valuation approaches—income, market or cost—that works best for a particular assignment. All three approaches use fair market valuation. Mark O. Dietrich, CPA, ABV, of Dietrich & Wilson, PC, an accounting firm specializing in business valuations and health care consulting in Framingham, Massachusetts, says, “In any valuation transaction subject to regulatory review (and most are), fair market value is almost certain to be the required standard of value.”
The following are some examples of how fair market valuation approaches are applied: Income approach. Value is based on historical or projected income and valuators commonly use the discounted cash flow (DCF) method to determine it. The discount rate reflects the return an investor would demand from a company’s stock and incorporates perceived investment risk based on the company’s size as well as its market sensitivity. The valuator may use the DCF method to show how the entity’s value changes over a five-to-ten-year time period. Until standard setters develop separate business valuation standards, Dietrich advises CPAs to carefully study the definitions of projection and forecast in the AICPA Guide for Prospective Financial Information. “A projection is defined as a what-if scenario, while a forecast represents management’s best estimate of its most likely course of action and the most likely outcome of a business’s operations. Clearly, CPAs should use a forecast as the basis for a valuation conclusion,” says Dietrich. While there are several acceptable variations of performing individual steps within the DCF method, the critical steps that valuators must perform are:
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Calculate the present value of the free cash flows of the forecast period and residual value. Exhibit 1 illustrates the final steps of the DCF method, subsequent to forecast development, calculation of free cash flows, and discount rate determination. The forecast development projects a hypothetical company’s operating cash flows for 2001–2006 (including the terminal year which represents the anticipated long-term performance of the company based on management expectations and the industry outlook). The valuator determined the company’s residual value (the value of the company at the end of the forecasted period) using the Gordon Growth model, which assumes the cash flows of the company will grow at a constant rate after the terminal year (other methods of determining the residual value include applying a market-place multiple to the terminal year cash flow). The valuator discounted the residual value and the interim cash flows back to their present value using an appropriate discount rate to capture the risks as well as the perceived return an investor would demand for investing in the company. The valuator obtained the discount rate by using a variation of the capital asset pricing model (CAPM): (discount rate = risk free rate + (beta 5 equity risk premium)). Beta represents the volatility of the market. The enterprise value of the company was approximately $10.2 million as of December 31, 2000. The enterprise value does not represent the equity value, but rather the total value ( equity plus debt ) of the company. After determining the enterprise value, the CPA may calculate the equity value (stock price) of a company, including the removal of the company’s debt component. In addition, he/she may apply a minority interest discount or premium for control, as well as a discount for the lack of marketability (primarily for private companies). Physician practices: The income approach is preferable for valuing physicians’ practices, and valuators use the DCF method for analyzing a practice’s fee-for-service and capitated revenue (a dollar payment per patient per unit of time that covers specific services and administrative costs). Traditionally, valuators performed medical practice valuations for physician buy/sell agreements, divorce litigation and estate planning. Today, medical practices are larger and more complex, as are the valuations. CPAs will perform the valuation for clients for a number of reasons: a joint venture, group practice merger or practice acquisitions by nonphysician entities forming (or breaking) integrated delivery systems, which may include insurers, HMOs and government agencies. Home health agencies: The DCF method will become more useful in valuing a home health agency as these entities develop a better understanding of their actual and expected future performance under Medicare’s new prospective payment system (PPS), which became effective last October and reimburses service providers specific or predetermined amounts. Once the home health agencies are able to provide reliable income projections under PPS, valuators can recommend to their clients providing services at minimal costs to achieve profitability. Market approach. This approach, which compares an entity with similar ones, allows the valuator to choose either the guideline company methodology or the merger and acquisition methodology. Both valuation methods have many procedures in common. They are based on the capitalization rates of health care providers, either publicly traded or recently sold, which are considered comparable to the company being valued (the subject company). The guideline company methodology relies on the current market price of comparable publicly traded health care companies. The valuator determines the subject company’s equity value by applying pricing ratios of publicly traded stocks to its relative performance. Valuators use the guideline company method to value these entities: hospital systems, nursing homes and home health care organizations. CPAs can also apply this method to diversified health care delivery systems by including a review of the pricing multiples of several health care providers. When comparing the subject company to publicly traded ones,valuators must adjust comparisons for differences in size, profitability, service mix, reimbursement sources and geographic diversity. For example, if the subject company had lower profitability and a smaller revenue base, then all else being equal, the CPA should apply lower pricing multiples to it rather than those suggested by the median multiples of the guideline companies. On the other hand, if the company has a mix of services with more growth potential or a higher concentration of private-pay reimbursement sources, that may warrant a higher multiple. Exhibit 2 illustrates one example of how a valuator works with the guideline company methodology, using ten companies selected and analyzed for a comparison to the subject company. The valuator obtains the revenues, EBITDA, EBITDA margin and depreciation levels from SEC filings. Their market capital levels equal the number of shares outstanding for each company multiplied by their respective stock price as of the valuation date of the subject company, and that number is added to their respective total capital debt balance. The valuator calculates pricing multiples of the guideline companies (market capital to revenues and market capital to EBITDA), selects the multiples to apply to the subject company’s operating performance and makes adjustments based on various factors including size and profitability comparisons. For instance, the valuator chose a 20% reduction to the selected median multiples due to size differences—the subject company is considerably smaller than each of the guideline companies ($30 million in revenues vs. a median of $135 million for the guideline companies). The subject company, however, is on the higher end of profitability (4% EBITDA margin vs. the 3% median EBITDA margin). As such, a slightly offsetting 10% upward adjustment was applied to the market capital to revenues multiple. In general, the higher the profitability of a company, the higher the company’s market capital to revenue multiple. The valuator then applied the adjusted multiples to the operating performance (revenues and EBITDA) of the subject company, calculated the average of the two outputs (approximately $7.3 million) and determined the appropriate enterprise value of the subject company. As shown in exhibit 1 , the valuator needs to remove the debt component from the enterprise value to arrive at the subject company’s equity value. Since the stock prices utilized in determining the market capital for each guideline company represent the share prices of the guideline companies’ stock, the enterprise value conclusions represent a minority interest (noncontrolling) basis. Also, while other critical factors exist in comparing the subject company with other companies (such as differences in growth prospects), only size and profitability were captured in exhibit 2 . In assessing single medical practices, CPAs may find that comparing them with publicly traded companies is not particularly useful. The market capitalization rates of public companies that manage medical practices may reflect growth expectations that a single practice cannot duplicate; companies that manage medical practices are not in the business of actually providing health care. “The application of market multiples to medical practices using the guideline company methodology can produce unreliable indications of value, especially in light of recent turmoil in this sector of the financial markets,” says CPA Michael Heaton, ABV, CVA, of Heaton & Eadie in Indianapolis, an accounting firm specializing in health care consulting. The merger and acquisition method, or comparable transaction method, values a company’s equity based on recent sales of comparable health care companies by applying pricing ratios based on individual sales transactions to the company’s performance. This method is frequently used for valuations of home health agencies and nursing home agencies. The merger and acquisition method parallels the guideline companies method. However, instead of deriving the market capital of a guideline company to determine its respective pricing multiple, the CPA valuator uses the actual deal value paid in a selected transaction in which the acquired company shared similar operating characteristics to the subject company to be valued. The conclusions derived in this method represent value on a controlling interest basis since the transactions used in the analysis reflect purchases of control. The conclusions derived from the guideline companies method, however, reflect a minority interest basis. The merger and acquisition method works best for both parties to a potential business combination when the CPA can find enough similar transactions to make an accurate comparison—many transactions will give the CPA more insight than a smaller number, which limits the market comparison. The terms of the sale as well as the operating characteristics and the financial performance of the acquired company are critical pieces of information. Medical practices are sometimes sold based on comparable operating characteristics such as revenues, full-time physicians and number of people with managed care contracts. But using the merger and acquisition methodology for medical practices “can produce bizarre valuation results,” cautions Heaton, “especially if the comparison data are incomplete or do not disclose unique characteristics of the transaction, such as unusual compensation agreements subsequent to the merger.” Cost approach. Also called the net asset approach, this focuses on individual asset and liability values from the company’s balance sheet adjusted to fair market value. CPAs may use the cost approach when the subject company has a heavy investment in tangible assets or when operating earnings are insignificant relative to the value of the underlying assets. Comprehensive cancer centers, ambulatory surgery units and imaging centers are typically valued based on assets. But as surgery centers transform into more mature operating businesses, “they generate more predictable cash flows, so using the cost approach becomes less appropriate,” notes Heaton.
MAXIMIZING VALUE CPAs who perform valuations in any of the health care segments ultimately want to produce a report for the client that identifies all the relevant variables, states assumptions and provides supporting calculations on the estimate of the value of the client’s business (see “Steps to Performance Benchmarking,” above). Here are factors valuator’s should consider when analyzing the various industry segments: Hospitals. Traditionally, hospital valuations were based on price-per-bed multiples. Today, with outpatient services generating a significant portion of the average hospital’s revenue and occupancy rates low, the price-per-bed multiple has lost its relevance. For similar reasons, valuations based on real estate holdings can be irrelevant in those situations where hospitals operate outpatient facilities at separate locations from their main facilities. CPAs instead should rely on earnings as a measure of value. The value of a hospital depends on the scope of services it offers as well as on how much patients use them. The hospital’s progress in developing lower-cost services and managing existing ones is an important determinant of value, particularly as most hospitals shift to lower-cost services to remain competitive amid consolidations. Hospitals converting from not-for-profit to for-profit status need an independent opinion on the value of the entity. Hospitals consolidate or merge to limit overhead, contain costs and address managed care pressures. Owners and management use valuations of them to determine equity allocation post-transaction. Assume, for example, that hospital A merges with hospital B. If hospital A and hospital B are valued at $20 million and $30 million respectively, then the ownership of the merged entity would be allocated 40% to former shareholders of hospital A and 60% to those of hospital B. The valuator must factor in the key value determinants, such as a broad array of services, flexible cost structures, tight utilization reviews and good physician relationships. The valuator must also assess local market needs and the status of other hospitals competing for the same referrals. Using the DCF approach, a CPA can analyze a hospital under various operating scenarios. He or she can project varying revenue growth based on different assumptions about demographics, competition and service pricing and can vary the operating margins to incorporate overhead reductions or changes in service mix. Health care valuators’ practice of analyzing various operating scenarios, whether for illustrative purposes or corporate planning, is not restricted only to hospitals but may be appropriate across various health care segments or other industries. Valuators will choose different scenarios for review by the subject company’s management to help assess strategic objectives and understand the sensitivity related to a particular input or assumption. The matrix in exhibit 3 shows a range of values, derived from exhibit 1 , from changes to the discount rate and the long-term growth rate, assuming all else is equal. For example, applying a discount rate and growth rate of 18% and 4%, respectively, to the scenario in exhibit 1 , yields an enterprise value of approximately $8.7 million ($8.7 million = $4.2 million + $4.5 million; calculations are not shown but relate to present value of operating free cash flows and residual value, respectively). Medical practices. In any analysis of a medical practice, the valuator should consider: Practice and specialty type may affect the valuation due to regulatory changes (whether recently implemented or soon to be effective), demographic trends such as shifts in population age or medical advances (intellectual, equipment), any of which may affect a practice’s service and payor mixes. Factors such as facilities and payment mix may affect the forecast provided by the subject medical practice. A practice relocation may be accompanied by higher rental costs, resulting in decreased operating margins. However, an anticipated increase in revenues as a result of the relocation may improve operating margins; a change in payment mix resulting from the payor demographics related to the relocation can affect anticipated earnings. The amount of time a physician spends with a patient may be a factor of patient demand, service mix or the health or experience of the physician. Either consistent or erratic levels of historical profitability for a medical practice may have an impact on the CPA’s assessment of the riskiness and reliability of the practice’s future financial performance. One of the most critical considerations in medical practice valuation, for buyer, seller and appraiser, is the level and nature of physician compensation because it typically represents the largest expense. It is important for the valuator to examine compensation levels based on region, speciality and experience. The age and health of the physicians within a practice, as well as the quality of the administrative staff, may affect the discount rate applied to the cash flows in using the discounted cash flow methodology, due to changes in the level of perceived risk factors related to the particular medical practice. Lucy Carter, CPA, of Horne CPA Group in Goodlettsville, Tennessee, says that the valuator must be aware of the state laws and rules and regulations affecting the valuation, and of its intended purpose. “Appraisals for transactions with institutional buyers, such as hospitals, may raise certain compliance questions, while transactions with not-for-profit entities and foundations incur additional scrutiny from both the IRS and regulatory agencies charged with monitoring fraud.” Nursing homes. When valuing a nursing home, a CPA must specifically address the service area covered, current and proposed changes affecting reimbursement sources, services offered and the attributes and condition of the company’s facilities. The valuator’s analysis of the service area should highlight demand trends based on demographics. In many states nursing homes usually have very high occupancy levels because stringent state requirements restrict construction of new facilities. Another important factor in valuing nursing homes is the reimbursement source because reimbursement affects profitability. Since Medicaid, a state-administered program, is the major reimbursement source for many nursing homes, the valuator’s analysis must take into account the Medicaid programs in each state in which the nursing home operates. Thomas Fulton, CPA, manager of Rosenfarb Winters, LLC, an accounting firm specializing in business valuations in Tinton Falls, New Jersey, says, “The long-term-care industry has suffered greatly in recent years with the majority of the big nursing home chains going out of business. Government regulations in this industry are now designed to protect the patient at the expense of health care facilities by increasing operating costs and reporting requirements.” Some nursing homes have expanded into greater revenue-producing services, such as sub-acute, rehabilitative and other forms of specialty care. However, there are risks associated with specialty care, not the least of which is changing demand. The valuator must analyze the age, condition, capacity constants and ownership of each facility, as well as future capital expenditure requirements beyond routine maintenance. Home health agencies. Changes in Medicare reimbursement are also revolutionizing the home health industry. Under the newly implemented prospective payment system, home health care providers are reimbursed only a set amount for care provided to Medicare patients. This will likely force them to consolidate to achieve economies of scale. As a result, the industry may be transformed from a multitude of mom-and-pop shops to mostly large regional or national health care companies that can provide low-cost services. Acquiring home health agencies has become attractive to hospitals, too. “The ability to be a full service organization and provide a continuum of care has driven hospitals to make acquisitions in the home health care industry. And the change in the reimbursement methodology to a prospective payment system has made certified agencies more attractive than in the past years, which has affected current valuations,” says Gary P. Carpenter, CPA, partner in charge of health care at Holtz Rubenstein & Co., LLP, in Melville, New York. In analyzing a home health agency, the valuator starts through discussion with management, then researches recent publications related to the segment and compares guideline company information obtained through SEC filings and press releases. The valuator obtains data from management about these factors: WATCH OUT FOR REGULATORY RISKS When CPAs undertake health care valuations they must be mindful of the state and federal regulations that affect the valuation process and its calculations. Inexperienced valuators might overlook subtleties in any of the approaches that could lead to serious valuation errors. Dietrich offers a caveat regarding the use of traditional approaches because they do not always focus sufficiently on the analysis of revenues and related regulatory factors. For example, significant regulatory risks are associated with the earnings stream if the provider employs improper billing practices. In such a situation, whether the practice is inadvertent or deliberate, the value of the business may be worth less than cumulative penalties should the government conduct an investigation and find the provider liable. “Valuators are not accustomed to assuming an earnings stream may be at risk for civil or criminal fraud, changes in legislation at the state or federal level or subject to a re-allocation of government revenues to pay for new services, particularly those arising from technology,” says Dietrich. To keep abreast of ever-changing regulations, CPAs must know where to access information and avail themselves of appropriate online services (see “Business Valuation Sites on the Web,” below). “Health care valuation is an extremely risky practice area due to civil and criminal statutes which are unique to the industry,” observes Dietrich. “CPAs unfamiliar with these statutes, which cover such diverse areas as compensation plans in physician group practices and referrals between physicians, hospitals and home health agencies, are unlikely to identify problem areas which would affect their conclusion of value.” ENORMOUS CHANGES Managed care and health care reform have forced a dramatic restructuring of the health care industry and blurred the lines between the traditional segments. CPAs who perform health care valuations work in a very dynamic and challenging industry and must be aware of marketplace issues and changes affecting value determinations for their clients. Business valuation is not just plugging numbers into formulas; it is both science and art. Valuators must conduct more sophisticated valuations that address the regulatory environment and current industry trends of continued mergers, joint ventures and the breakup of existing affiliations. By examining internal and external factors relevant to the business and doing a thorough investigation, the health care valuator will develop the most probable and reliable value estimate.
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THE HEALTH CARE INDUSTRY HAS UNDERGONE significant change over the last decade, affecting delivery of services, payment mechanisms and providers’ organizational structure. Throughout a company’s lifecycle, certain events or business necessities—such as ownership transition, compliance with legal and regulatory issues and strategic planning—may require an independent appraisal of a business’s capital structure. 
he health care industry has undergone significant change over the last decade, which has affected delivery of services, payment mechanisms and the organizational structure of providers. It’s no secret consolidations and reduced government reimbursements have an ongoing impact on the health care industry. Because of the specific characteristics and unique attributes of each industry segment, CPAs who perform health care valuations have tended to specialize—in physician practices, for example, or not-for-profit hospitals. Health care industry valuation is a growing practice niche that provides an opportunity for CPAs to exercise the communication, research and analytical skills that go beyond traditional accounting. To ensure their clients do not operate in a vacuum in the face of industry trends, CPA valuators need to know the fundamentals in a variety of segments and understand the current demand for services, the forces affecting reimbursement and opportunities for growth in the health care segment being analyzed. 
Five years of historical financial statements. 
Develop financial statement projections. 
