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Understanding the New “Mixed” Economy

Musings of an Informed Thought-Leader

By Somnath Basu PhD, MBA

Brief Excerpt

The recent debacle in the financial markets has opened up a plethora of issues that require serious attention from all market participants. Perhaps the most serious concern is the emergence of a “mixed” economy where both “public” and government-owned enterprises will coexist with “private” enterprises.

Review of Past Performance

Unfortunately, the historical performances of such economies have been fairly dismal. The debacle is also bound to usher in additional regulation of financial markets. The new regulations are likely to focus on ways to control the possibilities of similar failures in the future.

Assessment

However, the structure of regulation should not be constructed on the basis of how the markets failed the people but instead on how people failed the market. The ramifications of the debacle require our attention and understanding, especially the possibilities of the existence of a regime of both high inflation and high market volatility. 

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What is an Initial Public Offering [IPO]?

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Physician Investing Basics

[By Julia O’Neal MA, CPA]

When companies first go public they issue stock in an initial public offering (IPO). Most of the time these stocks are sold in large blocks to institutional investors and it is only after they begin trading on the exchanges that individuals, like physicians, can buy them. Sometimes these issues are very desirable—they may rise significantly even on the day of issuance. 

However, over the longer term the excitement tends to dissipate, and it is much easier to evaluate a company once it has settled into a “trading range.” 

Outstanding Stock 

Once stock is sold to the public it is called outstanding.  

Primary Offerings 

A company’s corporate charter usually has authorized more stock for future issuance. When this stock is issued it is called a primary offering (as distinguished from the IPO).  

Secondary Offerings 

A secondary offering is the re-issue to the public of a large block of shares that has been previously held by a large investor. A primary offering is issued by the company itself and a secondary offering is handled for an outside investor by investment bankers. 

Rights Offerings 

More shares of stock in a company with the same assets dilute the value of the currently outstanding shares. When more stock is offered to the public, existing common shareholders have a right to buy enough shares to maintain their proportionate share in the company—they are offered the opportunity in a “rights offering,” and usually the shares to be purchased with preemptive rights are offered at a subscription price below current market price. 

Rights, like warrants, allow an investor to buy a certain number of shares or portions of shares at a certain price and may be traded.  Unlike warrants, rights expire after a certain period of time. When offered rights, an investor should examine the offering prospectus to determine what the newly raised capital will be used for. 

Stock Buy-Backs and Treasury Stocks 

Outstanding shares are attributed their pro rata portion of earnings. When companies buy back their own stock in a “stock buyback,” it is called “treasury stock” and does not participate in earnings or dividends.  This action reduces the number of shares and makes existing shares more valuable while allowing them to receive a larger portion of earnings.

It is positive for a company to buy back stock and negative for it to issue more stock—more outstanding stock is dilutive to earnings and to the value of existing stock.  It is also positive when management of a company (“insiders”) buys stock—it usually means that those closest to the company believe it is undervalued.

Warrants 

Warrants are attached to bonds in order to allow the bond issuer to make the securities attractive with a lower-than-market coupon. Warrants also have a subscription price that is usually lower than the market price of the stock, so once they are separated from the bonds they have an intrinsic value. Warrants may remain effective for several years or in perpetuity. Dividends are not paid on warrants.

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Are Capital Markets Efficient?

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What is the Efficient Market Hypothesis?

[By Jeffrey S. Coons; PhD, CFA]

[By Christopher J. Cummings; CFA, CFP™]fp-book1

The Efficient Market Hypothesis (EMH) states that securities are fairly priced based on information about their underlying cash flows and that physician investors should not expect to consistently outperform the market over the long-term. 

 EMH Types 

There are three distinct forms of EMH that vary by the type of information that is reflected in a security’s price:

·  Weak Form: This form holds that investors will not be able to use historical data to earn superior returns on a consistent basis.  In other words, the financial markets price securities in a manner that fully reflects all information contained in past prices.

·  Semi-Strong Form: This form asserts that security prices fully reflect all publicly available information. Therefore, investors cannot consistently earn above normal returns based solely on publicly available information, such as earnings, dividend, and sales data.

·  Strong Form: This form states that the financial markets price securities such that, all information (public and non-public) is fully reflected in the securities price; investors should not expect to earn superior returns on a consistent basis, no matter what insight or research they may bring to the table. 

While a rich literature has been established regarding to test whether EMH actually applies in any of its three forms in real world markets – probably the most difficult evidence to overcome for backers of EMH is the existence of a vibrant money management and mutual fund industry charging value-added fees for their services. 

In fact, no less than Warren Buffett has suggested that the markets are decidedly not efficient. 

Assessment

And so, while there has been a growing move towards index funds – as well as ETFs – the strength of the money management industry may reflect investor’s concern with risk management and asset allocation – as much as any view that a manager or individual can “beat the market.”   

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Your Biggest – Dual Asset

Why a Medical Practice is Both a Financial and Non-Financial Asset

By Dr. Gary L. Bode; MSA, CPAgary-bode5

A medical practice is a valuable asset in two respects.  First, it provides the work environment that generates your personal income.  It is a current financial asset.

Second, it has inherent sales value that can be part of an exit (retirement) or transfer strategy. It is a potential future financial asset. Some of this inherent value lies in the current market value of medical equipment, minus any money owed. 

The other aspect of inherent value is goodwill, or the worth of the practice as on going concern that allows you to sell it to another practitioner.  But, there are other non-financial rewards, as well.

Non-Economic Rewards of an Efficient Medical Practice

Some of the rewards of a well-run practice that transcend purely financial considerations include: 

1) A better, more consistent clinical result

2) Improved patient perception which increases referrals and decreases liability

3) Less employee turnover

4) Less stress

5) More free time for the practitioner.

Now, can you think of any other non-financial rewards? But, in the era of healthcare reform, are they increasing or decreasing?

Conclusion

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Medical Economic Value-Added Accounting

Understanding MEVA?

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It is not unusual for a medial practice to incur extra-ordinary expenses by investing in technology or equipment. But, did you know that there are two methods of evaluating these capital expenses?  

·   The older Generally Accepted Accounting Principles (GAAP) removes them from the income statement that is used to evaluate enterprise profitability.

 ·  The newer Economic Value Added (EVA) approach treats them differently by considering both capital expenses and operational expenses when calculating profit.  

Introduction 

The concept of EVA was developed by New York City-based consultancy Stern Stewart. MEAV is a riff off this distinction applied to medical practice capital investments by distinguishing between illusory profits and real economic gain.  

The concept is useful to keep physician executives from disrupting the balance sheet by chasing profits. It may also better reflect enterprise value since to have a positive MEVA – practice revenues must exceed operating costs, taxes and a charge for the cost of capital (debt interest rate charges, or the risk of saving/conserving capital rather than spending/investing it).

In other words, the benefits of major equipment must be weighed against the financial drain of purchase. Additionally, taxes are also left out of a GAAP analysis of operating profit, but MEVA expensing includes them to keep operations as lean as possible.

Nevertheless, the MEVA formula may be expressed, as follows: MEVA = NOPAT – (Cost of Capital X Capital)orMEVA = (Operating Profit) – (A Capital Charge) where: NOPAT = (Taxable Income – Income Tax)where: Cost of Capital X Capital) = Depreciation X (Beginning Book Value).

As seen in the MEVA equations, there are two key components.  The net operating profit after tax (NOPAT) and the capital charge, which is the amount of capital times the cost of capital. 

NOPAT is the profit derived from operations after taxes, but before financing costs and non-cash bookkeeping entries. 

In other words, it is the total pool of profits available to provide cash return to the physician executives who provided capital to the practice.  The cost of capital is the minimum rate of return on capital required to compensate physician debt and equity owners for bearing risk – a cut-off rate to create value. 

On the other hand, capital is the amount of cash invested in the practice, net of depreciation.   

Criticism of MEVA Calculations 

It is important to note that the above only represents one of the many ways to define MEVA.  In reality, the definition of MEVA should be tailored to the specifics of the practice that uses it.

Also, in reality, there are adjustments that may change the way a practice defines MEVA. These equity equivalent (EE) adjustments are used to both NOPAT, and the capital employed, to reduce non-economic accounting and financing conventions on the income statement and balance sheet.  Equity equivalents (EEs) are adjustments that turn a practice’s accounting book value into an economic book value, which is more accurate measure of the cash that physician owners have put at risk and upon which they expect to accrue some returns.  

Equity equivalents turn capital-related items into more accurate measures of capital and include revenue-and expense-related items in NOPAT, thus better reflecting the practice’s base upon which owners expect to accrue their returns.

Furthermore, equity equivalents are designed to address the distortions suffered by traditional financial ratio measures, that change depending upon the generally accepted accounting principles adopted or the mix of financing employed. 

Moreover, the basic formula for MEVA tends to produces a more conservative picture of ROI, and medical practice profits or losses. 

Summary 

Therefore, MEVA should not be used too rigorously for fear of excessive risk aversion and the paralysis of analysis. Your experience with this concept is appreciated. 

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Medical Practice Worth

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Introduction to Healthcare Business Valuation

By Bruce G. Krider; MHA56371606

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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