Posted By Joel Wittman, MS,MBA
Given the uncertainty created by Obamacare, health care companies have begun seeking consolidations through mergers and acquisitions as one of their future survival strategies.
This question of the value of a company frequently arises in conversations with owners, principals, and management of health care entities. “Sure I’d sell my business. Sure I think that we’d make a powerful team. One question, though: How much is the business worth?” The short answer is – it all depends.
To begin to understand the value of a company, the fundamentals of value must be explained. A correct standard of value has to be established. Fair market value fundamentals are based on the average price for the average buyer with neither party compelled to buy or sell and both parties being informed of the relevant facts. Consequently, fair market valuations are typically at the lower range of the market. Investment value fundamentals, however, are based on a specific price for a specific buyer and are based on an investor specific basis. Ergo, value is extremely buyer dependent. A company is worth what a buyer is willing to pay for it. It’s like a home plate umpire in baseball. The batter lets a pitch go by and then asks if it was a ball or a strike. The umpire’s answer: “It’s nothing until I make the call.” It’s the same with the value of a business – it is worth what a buyer is willing and able to pay.
It is not my intention to be facetious about this topic but there is not a clear answer to the question. There are common valuation techniques that establish parameters and metrics for valuing businesses. Among these techniques are the calculation of the Net Book Value of a company, the use of Public Market Comparables, the creation of a Discounted Cash Flow model favored by financial buyers, the use of Comparable Transactions of similar companies if the data is available, and ,the most common metric, the application of a Multiple of Earnings (after the appropriate level of earnings has been established – but that’s for another time). Which leads to the question of how are multiples established? Remember, value is extremely buyer dependent: one buyer may be inclined to assign a higher multiple to earnings than another buyer based on the first buyer’s reasons to complete an acquisition. However, the range of multiples can be tied to the level of risk the buyer is willing to tolerate to “make the deal.” Each buyer has a specific rate of return they would like to achieve from their investments. An acquisition is another form of investment and can this investment earn a return comparable to, or greater than, other investment opportunities.
The range of value and assignment of a valuation metric is dependent on the risk of the investment. The risk reflects the buyer’s required rate of return. The lower the perceived risk, the higher the value metric; the higher the risk, the lower the metric and, intuitively, the lower the price. However, there are determinants of risk that are specific to a company and can be managed by the company. Among these are having:
• diverse referral sources (the more, the better; the company is not overly reliant on one or two sources for its revenue stream)
• a diversified product and revenue mix which can lead to a more predictable revenue stream
• a diversified payer mix – don’t be too susceptible to changes in reimbursement
• the influence of managed care on the company’s revenue stream – This typically
leads to lower reimbursement. If a client of a medical staffing company ( such as a hospital) receives a large portion of its reimbursement from managed care payers they are less able and willing to pay full amounts for your company’s services.
• middle management strength - One of the most harmful things that you can indicate to a prospective buyer is that “you are the business” and that it cannot function without you. Buyers are justifiably concerned that there will be a precipitous decline in revenues post transaction if this exists. It is imperative to develop your management staff to the level of being able to function in your absence.
• knowledge of your current business trends. Is yours a stable and growing business that presents lower risk to a buyer? What are the business trends in your marketplace?
• knowledge of your competitors – Are they aggressively soliciting business? How many competitors are there in your market? The fewer the number of competitors, the more predictable is your company’s revenue stream.
• efficient accounts receivable management – This provides a snapshot of your operating infrastructure and management capabilities to a buyer. The lower your company’s bad debt expense and days sales outstanding (the average time it takes to convert a sale into cash), the more predictable is your revenue stream, the lower is the perceived risk to the buyer, the higher valuation metric can be assigned to your business. Management and control of these company specific determinants of risk to the extent possible will increase the potential purchase price of a company.
Read my post in next month’s blog to learn about what strategies to implement to enhance the value of an M&A transaction.
Joel Wittman is an Adjunct Associate Professor at the Wagner School of Public service of New York University. He is the proprietor of both Health Care Mergers and Acquisitions and The Wittman Group, two organizations that provide management advisory services to companies in the post-acute health care industry. He can be reached at firstname.lastname@example.org.