Introduction to Healthcare Business Valuation

By Bruce G. Krider; MHA

This post provides an insight into the issues involved in buying or selling a healthcare organization or business.  Its purpose is to provide the reader with greater understanding of the process and the concepts conveyed within do not represent valuation “advice”.  

Whether acquiring or divesting, we strongly recommend that you consult with valuation professionals with demonstrated experience in healthcare transactions of the type of you are considering. 

Business valuation measures two things (primarily): tangible assets and intangible assets.  Let’s discuss some examples of intangible assets first. 

Intangible Assets: 

Owners of clinics or hospitals often tell me, “Well, this is what we generate in terms of income but we really don’t know what that business activity is worth.” Healthcare services are obviously a “personal services” business. The value of the business which has been built is a patient base which may be reflected by patient records or databases, but it also includes that which has been put in place to make the business function and generate a revenue stream. An assembled and producing business takes trained professionals fused together and ready to provide services. These services are provided according to policies and procedures, which have been developed and in place. 

Further, all of these things are wrapped within a business context.  That is, the business itself has been legally established. Any necessary licensees have been obtained.  Facilities have been secured or leased. Contracts have been set. 

In summary, it takes time and money to build a business. When a going business steadily generating a relatively predictable income has been established, we recognize the value of that expended effort and those results.  It is, after all, why business people decide to forego that effort and buy a business rather than build one from scratch.  All of these things represent the intangible asset called “goodwill” or “going-concern value”. 

Tangible Assets

Tangible assets are sometimes referred to as “hard assets” and include furnishings, fixtures, medical equipment, medical supplies and any leasehold improvements applicable. 

In the valuation of hospitals (versus physician clinics) for the purpose of acquisition or divestiture, tangible assets are not necessarily itemized and/or valued.   They are assumed covered in the acquisition figure.

One might ask, “How or why is this different from valuing good-will and equipment, furnishing, fixtures and leaseholds in clinics?” The answer is simply that this is how the market has traditionally approached the value of hospitals and major clinics versus physician practices or smaller clinics from a market value standpoint.

Appraisals for others purposes, such as ad valorem related appraisals would indeed, value the real estate and the personal property. 

Value Importance of Tangible vs. Intangibles

For clinics and physician practices the majority of the value usually lies in the intangible assets (goodwill). Further, that goodwill is, more than anything, based on income production.  In turn, the income is a function of those resources and efforts expended on the part of the developer of the business. 

In some specialties, there obviously may be a greater percentage of value going to equipment. It would be the unusual case, however, where the equipment value would approach the goodwill unless the business was performing less than it should. 

The Important Role of Risk Determination

An extremely important element in the valuation process is the determination of risk for the investor.  The process is complicated and time consuming.  The reason for the importance and pivotal nature of risk determination is that, it must be quantified and factored into the valuation calculations.

The business valuation expert must accurately quantify the risk associated with the practice, clinic, hospital or healthcare center as of the date of the appraisal.  The impact on the resulting value is significant. 

Valuation Process

In valuing healthcare organizations, there are several basic tasks.  The first is the development of a model for projecting income and expense. (The value of a business relates directly to the determination of a reasonable anticipated revenue stream). This is usually projected for a period of six years, (five years for standard projection and a sixth year to be used as a surrogate for reversion or “in perpetuity”).

Present Value or Discounted Cash Flows 

The second task in the valuation process is the determination of risk associated with the subject organization.  One of the best starting points for these risk factors is from the market itself. When reviewing sales of similar organizations, we can derive capitalization rates by dividing the revenue by the sales price.  That can serve as a starting point. 

One often hears of “multiples” as a method of valuation.  A multiple is nothing more than the inverse of a cap rate.  In other words, if the cap rate is .20, the multiple is 1/.20 or “5”. Beyond that, one should refine the industry cap rate to reflect the specific nature of the subject organization.   

For example, we employ a subject sensitive grid and a set of criteria with associated weights that assists us in being as subjective as possible in developing our risk modifiers.

For illustrative purposes, if the clinic generates $10,000,000 per year and the adjusted cap rate we have developed is 20%, the value of the subject organization would be $50,000,000, ($10M/.20 = $50M) by this method.  Demonstrating the multiple the calculation would look like this: $10M revenue x “5” (1/.20) = $50M. 

Used in a “present value, discounted cash flow model”, we would use a similar discount factor with our six year pro forma to determine the organizations value.  The demonstration of this process by the business appraiser is one of the most important considerations an appraisal client should be aware of and understand.  It is also one to cover, thoroughly with the appraiser.     

Volatility of Cap Rates and Multipliers

It is important to note that the healthcare marketplace is a highly dynamic and volatile market.  Correspondingly, the amounts, which are paid by investors for healthcare investments, are also quite volatile. Cap rates vary substantially from year to year and from business type to business type.  

Noteworthy then is the recognition of the concept of a Range of Values in multiples and cap rates.  Examples of a range of values for multiples for hospitals might be 3 to 5x.  The variations in those multiples should be tied to the specific nature of the subject being valued.

In other words, if the industry norm is “4”, one needs to adjust that figure based on the strengths and weaknesses of the specific subject.  This is the purpose of the risk factor adjustment grid we mentioned earlier.  If the risk assessment is off in the valuation process, the value will be correspondingly off. 

Projecting Earnings

To develop a schedule of projected earnings, we review historical data, incorporate what we know about the trends in the field, in reimbursement, in expense increases, in any changes in contracts held by the subject organization (i.e. Preferred provider organization or managed care contracts), changes in the scope of service of the organization, changes in collection ratios, the changing marketplace and the expectation for future business volume, a changing referral base network, expansions of clinic or hospital locations, the addition or loss of specific key staff, etc.  The list goes on and on.

In Summary

In buying or selling service businesses such as healthcare businesses, there are numerous factors to consider.  Further, there is no marketplace more competitive or complex than the healthcare marketplace.   When considering what you are willing to pay for a healthcare business or what you want for a selling price, you must consider a great deal with an objective eye.

Often sellers view their practices from the standpoint of all the “blood, sweat and tears” they have invested and this may not be realistic. If a practice, clinic, hospital or other healthcare organization is overpriced, it will linger in the marketplace.

If there is one point to take from this post, it is that the selling price must be justified by the realistic anticipated revenue stream. 

In your case, how does the subject organization compare with the average of its type?What are the unique circumstances or considerations of the subject? Can your appraiser quantify them accurately?   

The Healthcare Appraisers

The healthcare marketplace is a marketplace unlike all others because of: 

• How healthcare organizations are structured literally, politically and for reimbursement and tax reasons
• How healthcare organizations are reimbursed 
• How different areas are paid differently for the same procedures.
• How medical research and development directly impacts the way healthcare is delivered and how that impacts the cost of operation.
• How technology impacts the obsolescence of hospital equipment and the ability to maintain the “standard of care” and how that impacts the value and future of an organization.
• How growing, numerous and regulatory requirements impact staffing, services, physical plant and equipment costs.
• How accreditation requirements alter how healthcare is delivered and impact costs.
• How the Medicare or Medicaid budget will change over the foreseeable future.
• How nurse shortages may limit an organizations ability to keep certain services available.
• How changes in decentralization of healthcare delivery impact others in the new healthcare marketplace.  
• Or, a myriad of other new and changing factors in the healthcare field; etc.

Therefore, when contemplating an acquisition or divestiture, make sure there is an appraiser on your side of the table who knows the industry. 

The author has 30 years of management and consulting experience in the healthcare field. As an adjunct professor for two university graduate programs in healthcare administration, he has authored numerous articles and books.  This complimentary article is from American Health Care Appraisal www.ahca.com

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