What is it, and why does it matter?
The Oncology Valuation Series
November 21, 2018
President & CEO of Verdi Oncology, Inc.
My job puts me in front of physician owners of medical oncology practices at least 4-5 times per month, and invariably the conversation gets around to valuation, and then inevitably to EBITDA. The instant EBITDA is put on the table, eyes start to glaze over; some of the participants are lost to incomprehensible financial jargon. The purpose of this blog is to level the playing field and show EBITDA for what it is; a simple, important but flawed financial metric.
EBITDA is the acronym for Earnings Before Interest, Taxes, Depreciation and Amortization. EBITDA has become a standard of valuation parlance, and is widely used by private equity firms in valuing acquisitions – including medical oncology practices. The term was popularized in the 1980’s by the high yield team at the erstwhile investment bank, Drexel Burnham Lambert, as a shorthand method for measuring cash flow for debt service.
The value of EBITDA is that it totally abstracts from capital structure (no provision for interest) and investment decisions/requirements (no depreciation, amortization or historical capital expenditure). EBITDA is not recognized by generally accepted accounting principles (GAAP) as a financial measure because, unlike free cash flow or operating income, it makes no provision for the requirement for asset maintenance through capital expenditures (as in free cash flow) or indirectly through depreciation and/or amortization (as in operating income). The value and appeal of EBITDA is that it is a clean spot to start the financial evaluation of a company or practice, without reference to prior capital structure or investment decisions.
EBITDA has three important limitations when evaluating medical practices:
- Most medical practices are structured as partnerships for tax purposes, and all cash is stripped out of the practice at year end. This makes it challenging to calculate the compensation of partner physicians, as it varies year by year, and there is no money left in the practice to approximate retained earnings. The physician owners of most medical practices deal with required investment for capital into the practice through a combination of direct personal investment and loan guarantees. This requires some estimation and agreement of compensation and annual required capital investment between physician owners and prospective investors to calculate EBITDA because, in a strict sense, most practices never have any historical EBITDA – it is always consumed in partner compensation.
- It is always important to separate both the expenses of the practice made on behalf of the physician partners (such as the leasing of automobiles) and non-recurring expenses (such as transaction fees and certain legal costs) to determine the actual ongoing EBITDA of the practice.
- Most medical practices function on a cash reporting basis, while GAAP requires accrual-based accounting. The principle difference between these two methods is that accrual-based accounting creates receivables to recognize revenue at the time of service. Cash based accounting only recognizes revenue when cash is received – consistent with the cash-based tax basis of most practices. Any professional investor will insist on an adjustment to EBITDA to accrual basis in a semi-audit called a quality of earnings analysis. In general terms, cash-based accounting will understate EBITDA in growing practices, and overstate it in shrinking practices.
The important take-away here, is that most investors will insist on an EBITDA based valuation analysis to invest in any medical practice. An important corollary consideration is that most practices have zero EBITDA before a transaction, and that the EBITDA is created through negotiations with the investor group regarding prospective physician compensation and benefits. Whatever EBITDA is agreed to, investors will normally require that an outside accounting firm conduct a limited audit on the agreed upon EBITDA before making an investment.
I always find that a couple of examples help to make these concepts more transparent, and easier to calculate on your own. Figure 1 above shows an example of two medical oncology practices. Practice A is simply an archetypal practice, with generally recognizable margins. Practice B is a similar practice, but one which made an investment in a controlling ownership stake in a technology company within the last year. Practice A has 5 partners, while B has 7. The balance of the assumptions regarding the salient differences between the practices are shown in Figure 3 below.
EBITDA is a useful measure for investors, but is of limited use in actual operational analysis, as it abstracts from both capital structure and investment requirements. While Practice A has lower revenue and EBITDA, it has substantially greater pre-tax income, and enjoys an almost 2:1 advantage over Practice B in free cash flow (FCF) per partner. In the course of normal operations, actual partner compensation comes from free cash flow – not EBITDA. Free cash flow reflects actual cash costs that must be paid prior to partner compensation, including both interest and capital investments.
Investors typically try to “normalize” practice EBITDA to eliminate non-recurring expenses, including both one-time events, and discretionary expenditures that will not be made post-investment. Figure 2 above eliminates both certain discretionary (partner autos) and non-recurring (expenses related to transaction) to derive an adjusted annual EBITDA and FCF. The adjustment process is important in determination of normalized EBITDA and FCF post investment. A comparison of Practices A and B shows a much closer financial performance thanks to the improved relative performance of Practice B due to these adjustments.
EBITDA has a dedicated following in the investment community, enjoying the reputation of a clean and easily calculated financial metric that allows the abstraction from capital structure and investment requirements. It is not endorsed by GAAP, however, and has several serious limitations – including the fact that the vast medical oncology practices never have any historical EBITDA until partner compensation is restructured and adjustments are considered. Finally, most practices operate on a cash accounting basis, which makes the final determination of EBITDA dependent on the work of an accounting firm to finalize an accrual-based EBITDA calculation.
Determination of EBITDA for any medical practice involves several levels of investigation and negotiation – it can never be determined in isolation by a third party for a typical cash-basis medical partnership. The question, “What is your EBITDA?” is always an invitation to begin negotiations.