Valuation Misconceptions in the C-Suite: A Special Top Ten List

April 21, 2015

It is truly amazing to consider the evolution that has taken place in the valuation profession over the past two decades. Technological advancements and numerous research studies have transformed the science of valuation, although the need for art – skilled judgment and reasoning – remains. Today, scientific methodologies provide a fact-based foundation for supportable financial theories of professional valuation experts. The market now has trained, credentialed professionals who are well-positioned to offer meaningful insights for business executives facing critical organization decisions.

Valuations have become a key process in the lifecycle of a business, and this is especially true in healthcare. Valuations are now being prepared for a variety of reasons, including transaction support, regulatory compliance, gift and estate planning, financial reporting, strategic planning and overall management of a business or healthcare entity.

Yet, in light of the advancements made in the science of valuation, it’s not unusual to hear senior executives ask valuation-related questions highlighting lack of knowledge or misconceptions regarding the value of a healthcare entity and the valuation process. This is understandable, considering the continual evolving theories of valuation, and the debates even among healthcare valuation professionals on the specific application of certain valuation methods.

In today’s ultra-busy world and constant overflow of information, the process of thinking about new concepts is most effective when it’s made to be fun and memorable. So, in the spirit of taking an entertaining approach to the misconceptions senior executives sometimes hold about the valuation process and the importance of utilizing professional valuation expertise, we would like to share a Letterman-style Top 10 List. In developing our list, we have to assume everyone understands that value cannot take into consideration the value of referrals. With that thought in mind…

From the Home Office of our Healthcare Team, the Elliott Davis Decosimo firm presents: The Top 10 Valuation Questions & Misconceptions Overheard from Senior Executives:

10. We “have to” get this deal done! Isn’t there some way to increase the practice value or the physician’s compensation so we can entice the physician to sell his practice?

The short answer is “no.” To find a “yes” requires leveraging knowledge of the target practice, experienced healthcare personnel knowledgeable of the target’s niche, and advice from a qualified valuation professional. The key to finding ways to increase value is to understand the fundamental revenue and expense drivers that impact the overall value of a practice. Comprehensive valuations address each driver in terms of risk and reward.

9. EBITDA is the same as cash flow, right?

EBITDA = Earnings Before Income Taxes, Depreciation and Amortization. EBITDA is a common earnings measurement formula used in transactions, and it is a widely-used indication of a company’s cash flows before certain deductions. Although EBITDA is not a GAAP measure, it is calculated by using information from the income statement. The primary issue with equating EBITDA to cash flow lies in the issue of capital expenditures. While depreciation may exceed necessary capital expenditures in a specific period, over time, healthcare and other entities must continue to invest in new or replacement equipment. EBITDA, most often, is not a true measure of cash flow.

 8. We keep hearing that everything in this sector (or market) is trading for EBITDA! Why isn’t the target we are considering worth 5x EBITDA?

Valuation multiples provide useful information, but they do not take the place of a comprehensive valuation. Executives should be aware that application of industry or rule-of-thumb multiples is a short cut to value, based on an oversimplification of in-depth valuation methodologies. Specifically, earnings multiples are the inverse of a capitalization rate, which is determined based on the risk associated with the earnings and the anticipated growth of the earnings.

The application of multiples is often a “back-of-the-envelope” calculation, typically using an average composed of both good and bad companies. Because there is no consideration given to the unique characteristics of the business – including comparative riskiness, growth prospects, cost structure, working capital and capital expenditures, use of a simple multiple doesn’t often work.

For a business owner and potential seller, the major benefit of a valuation lies in the in-depth knowledge gained from an understanding of the value drivers within his or her particular business – rather than the average business in the entity’s industry.

7. Why does post-transaction physician compensation affect value?

This compensation has a direct impact on post-transaction cash flows. Value rests in the anticipated cash flows of a business. If the selling physician accepts more compensation, the amount of cash flows will be reduced, and likewise if the physician is willing to accept less, the value of the practice will go up, all else being equal.

6. Can we “pay for” a physician practice’s intangible assets – i.e. workforce in place, medical records and trade name? Or, now that we’ve bought the practice, is all intangible value goodwill?

The immediate answer to these questions is “it depends,” and these questions highlight the necessity of considering the specific facts and circumstances of each proposed transaction. Any target has a total fair market value comprised of an assemblage of assets, whether tangible or intangible. Valuation methods under the income and market approaches generally yield a value inclusive of tangible and intangible value. Intangibles may be one or more components of value but the sum of the individual components of value cannot be greater than the total value.

Purchased intangibles and other assets are supported by the future cash flows of the business. If for example, owner-physicians receive 100% of post-transaction cash flows in the form of compensation, there would be no remaining cash flows flowing to the buyer to support the purchase of intangibles.

5. Why does it matter what personal expenses have been run through a practice?

Personal expenses of owner-physicians impact practice earnings. Personal expenses inflate operating expenses and artificially lower the physician’s compensation, and if not identified and adjusted, result in a lower overall value of the practice. Notwithstanding the potential income tax implications, personal expenses paid by a practice from a valuation perspective are considered additional compensation and may either be considered part of post-transaction compensation or be added back to earnings to determine practice value.

4. It costs how much for a valuation? Can’t I just get a “quick-and-dirty” valuation? Or, can’t you just “sign off” on the valuation our CFO prepared?

While often useful, a “quick-and-dirty” valuation is just that…quick and dirty. Quick-and-dirty calculations of value should be treated with the same regard as valuations based on applied industry average multiples. It is important that buyers and sellers fully understand the unique characteristics of the business that is under consideration prior to making critical organizational decisions. CFOs are experienced financial professionals and are a great resource to anyone preparing a valuation, but most are not valuation experts. Another consideration is the independent, impartial view taken by a third-party valuation expert. Given his or her relationship to the company, a CFO may be more likely to include bias rather than provide an independent and objective analysis. Valuation experts are exposed to a variety of transactions and maintain active databases and resources used in forming their opinion. At the end of the day, it’s worth paying a little more for a valuation if you can get a better return. Consider the following question: What do you want in your files to support the price from a compliance standpoint?

3. Hospitals can “pay more” for my business, because they have better reimbursement rates, right? Or, shouldn’t the purchase price be higher, since our operating costs will be lower than the seller’s?

Fair market value, or the current value of the target, is, by definition, determined based on a hypothetical buyer and seller. In other words, buyer-specific synergies should not be considered when determining FMV. There may be instances where the target’s historical financial performance requires adjustments to reflect cash flows available to a hypothetical new controlling owner, but these adjustments should not reflect buyer-specific upticks in revenue or cost savings. The consideration of buyer-specific synergies results in “synergistic value,” not fair market value.

2. What is the difference between enterprise value and equity value? Why isn’t there just one value for a business?

It is extremely important that potential buyers, sellers and valuation professionals be aware and on the same page about “what” may be transacted and, correspondingly, valued. In healthcare change-of-control transactions, asset sales are seen more often than stock sales. The related valuation would be prepared at the control level of value, and typically would report the “enterprise value,” or the total value of the business prior to any reduction of the debt. This is congruent with the typical arrangement in an asset sale, where the buyer does not assume the existing debt of the sellers. The “debt-free” purchase price typically is used to pay off all seller debts, with the remainder flowing through to the seller equity holders. Enterprise value is often used interchangeably with the terms debt-free value, total invested capital (“TIC”) or the market value of invested capital (“MVIC”). In contrast, if a minority interest of equity is contemplated, the value most likely determined will be the value of equity, prorated to the number of shares or percentage of equity under consideration, and discounted for lack of control and marketability factors as appropriate. A change-of-control stock sale potentially impacts the valuation process as well.

This question once again highlights the importance of considering the specific facts and circumstances of the proposed transaction. Although fair market value is always determined from the point of view of a hypothetical buyer and seller, specific facts about the transaction – especially, “what” is being sold and purchased – should be considered. In other words, the value is determined based on a hypothetical buyer and seller entering into the terms of the proposed transaction.

1. Every top ten list has a really good number 1, but we are betting your biggest misconception of valuation may not be on our list.

We are hoping you will help us update our Top 10 with your No. 1 valuation question. Did we miss your question or do you have a story to share? Please share your best valuation stories!

EMAIL us at elliottdavis@elliottdavis.com or TWEET your questions or your valuation stories to us at @Elliott_Davis using the hashtag #valuationtop10.

We Can Help

If you find yourself in need of valuation services, contact the healthcare valuation team at Elliott Davis Decosimo at 866-417-4059.

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