Medical Oncology Practice Valuation
Art and Science
The Oncology Valuation Series
November 27, 2018
President & CEO of Verdi Oncology, Inc.
“In the short run, the [stock] market is a voting machine but in the long run, it is a [scale].”
I was recently working with a practice and was inadvertently included on an internal email to all the practice partners that expressed complete bafflement at the valuation process, and the seemingly arbitrary determination of capitalization multiples. It was a wake up call – I was doing a very poor job at explaining the both the broad swings in calculated EBITDA and the derivation of the interrelated multiple. These are the two elements essential for a typical short-form enterprise valuation based on capitalized earnings, and deriving them is equal parts science and art – the essential time-bound skill referred to by Ben Graham in the quote above.
The concept behind capitalized earnings is simple; earnings are a proxy for the cash that an investment can generate, and investors are willing to pay a multiple of those earnings to own the rights to the investment (and its earnings stream) into the future. The multiple is simply the inverse of the discount rate (like the interest rate on a bond) that the investor applies to the future earnings to derive a value today – in investment parlance the present value of the investment.
I have shown a range of common multiples paid in medical practice acquisitions in Figure 1 below. It is important to note that these are applicable to typical EBITDA based acquisitions, and are substantially lower than comparable net income per share (EPS) multiples paid for publicly traded equities. This is for a variety of reasons including:
- Net income is always reduced by taxes, interest, depreciation and amortization.
- Price to Earnings (PE) ratios are only used to value the equity of a company, while EBITDA ratios value the entire enterprise, including debt.
- Publicly traded equities are liquid – they can be bought or sold whenever the stock market is open for business, and that liquidity reduces risk – increasing the multiple that investors are willing to pay for them.
- Information on publicly traded companies (including projections of future earnings) is supposed to be uniform in presentation and generally reliable – based audited results for historical financials, and on management and analysts’ best estimates for projections. Information on private companies is difficult to obtain, and then frequently quite difficult to interpret.
Not surprisingly, the fundamental issue in most negotiations surrounding purchase of a practice is the applicable multiple. There has been a lot of academic work over the years to determine what is the proper discount rate (inverse of the multiple) for any investment – based on its unique risk. This is captured in the capital asset pricing model (CAPM), the brainchild of Messrs. Sharpe, Markovitz and Miller (among others) which earned them the Noble prize in economics in 1990. In its simplest form the CAPM is:
Ra = Rrf + Risk premium
Where: Ra is expected return, Rrf is the risk-free rate (typically on government bonds) and the risk premium is determined by the unique characteristics of the asset in question. Putting some number to this equation, let’s say that the risk-free rate is 4.0%, and that the market risk for the stock market is 6%, yielding a general return requirement of 10%, or a capitalization rate of 10x. Let’s assume that the investment in question has a risk of 30% greater than the market, resulting in Ra = 4% + (1.3*6%) = 11.8%, or a capitalization rate of 8.5x.
While this model (and its derivatives) remain popular in major corporations and in portfolio management, it uses relative market volatility (exclusively a public market measure) to define and measure risk. Consequently, it is not directly applicable to private investments – at least requiring some art to determine the appropriate risk premium for any investment.
The foundation of valuation of private companies dates to Revenue Ruling 59-60; the 59th tax ruling promulgated in 1960, which dealt with the factors that the IRS would recognize in determining valuations of private companies. While this may seem like ancient history, these factors remain key determinants in private company valuation, including:
- “The nature of the business and the history of the enterprise from its inception.
- The economic outlook in general and the condition and outlook of the specific industry in particular.
- The book value of the stock and the financial condition of the business.
- The dividend-paying capacity.
- Whether or not the enterprise has goodwill or other intangible value.
- Sales of the stock and the size of the block of stock to be valued. (A measure of liquidity)
- The market price of stocks of corporations engaged in the same or a similar line of business having their stocks actively traded in a free and open market, either on an exchange or over-the-counter.”
Perhaps the best piece of advice given in the Ruling deals with the reality of the broad range of possible valuations for any company:
“Often, an appraiser will find wide differences of opinion as to the fair market value of a particular stock. In resolving such differences, he should maintain a
reasonable attitude in recognition of the fact that valuation is not an exact science. A sound valuation will be based upon all the relevant facts, but the elements of common sense, informed judgment and reasonableness must enter into the process of weighing those facts and determining their aggregate significance.”
My favorite approach to valuation comes from the 2013 paper The Entrepreneur’s Cost of Capital: Incorporating Downside Risk in the Buildup Method, by Chong, Jin and Philips. These guys suggested that the appropriate cost of capital for private company transactions is given by the buildup equation:
E(R) = Rf +RPm + RPs + RPu where:
- E(R) = Required return on a particular investment,
- Rf = risk-free rate
- RPm = general market risk
- RPs = risk premium for small size, and
- RPu = risk premium for company specific factors.
I find this concept compelling; it combines the derivation of the cost of capital from the CAPM with the practical valuation considerations of Revenue Ruling 59-60. Looking at the equation above, let’s assume the following: Rf = 4%, RPm = 6%, RPs = 2-5%, and RPu = 3%, yielding a cost of capital of 15% – 18%, or a capitalization multiple of 6.7 to 5.6; a normal range for private medical practices.
It is worth noting that I put a lot of importance in the company specific factor, RPu. Almost every private company or medical practice I end up evaluating, is one that I will also have some role in managing and building in the future. Consequently, more company specific risk, means more work for me; and possibly a draconian discount rate. Conversely, practices that offer specific capabilities or geographies may reduce our aggregate risk, and positively influence my view of company specific risk.
Ultimately, capitalized current earnings makes a central assumption about future financial performance of a medical practice – that it will continue exactly as it is today. This is impossible, and consequently almost all financial valuations ultimately use a model of future operating and financial performance, and a discounted cash flow to arrive at value. In these models, assumptions are made about future revenues, costs, capital requirements, profits and cash flows.
They include implicit and explicit assumptions about geographic service area, the nature of services provided, future levels of reimbursement, number of patients served and other critical assumptions. One of the key values of the financial models, is that they allow for sensitivity testing of financial results to operating assumptions.
Figure 2 above looks at an example where a practice with $2 MM in annual cash flow (EBITDA), growing at 5%, is acquired and sold with a 5 x EBITDA multiple, and a 15% discount rate. A point worth noting, is that most financial models will always require an assumption about a future sale – effectively balancing the initial cost. In this example, the sale multiple is held constant at 5x, and a 15% discount rate is used. The relative level of the discount rate (15%) to the acquisition discount rate (20%) and the growth in EBITDA combine to yield an IRR of 26% and a commensurate net present value (NPV) for the investment of $4,016.
Net present value is an old school method of measuring return against a specified discount rate, and is a summation of the future cash flows, which are individually divided by the discount factor for that period; calculated as PV for cash flow from period x = Period cash flow/ (1+E(R))^x. As an example, the year 5 cash flow present value = $15,315/(1+.2)^5 = $7.614. The arithmetic for this is shown in Figure 2 as well. Differences in NPV are due to rounding.
I like to do the individual discounted cash flows, and see what % are from normal operations, and what is due to the final year sale proceeds – the greater the % derived from normal operations, the lower the risk in the investment. In the example in figure 2, discounted cash flows (excluding investment) total $14,020, and the total PV is about 45% from operating cash flow, and 55% from the final year. I regard getting over 40% return on a PV basis in the first 4 years as low risk. On a non-discounted basis, the investment returns $9,051 in the first 4 years – almost 100% payback.
Figure 3 looks at the same acquisition, but with a 20% discount rate and no growth in EBITDA. As you would expect, this is exactly a 20% IRR model with approximately $0 NPV (differs from $0 due to rounding. While this would not be a very exciting investment, it does give a good idea about how the arithmetic ties together.
Finally, in Figure 4, we look at the unfortunate situation where the acquisition multiple exceeds the multiple at time of sale. In this sad example, the company grew by 5% per year – just to get back to break-even; thereby confirming the old axiom; Buy low sell high.
Getting back to the original motivation behind this blog, valuation is a complex undertaking, and is very much dependent on the opinions of the person doing the valuation; opinions about risk and the future. The arithmetic behind valuation is straightforward, but only serves as the framework for a whole series of educated guesses that make up the formulation of discount rates and future cash flows. At the end of the day, using a single capitalization multiple against a single financial metric, like EBITDA, is a shorthand process to a very complex underlying group of methods and assumptions. It seems to be what people want to use, but it is worth understanding that there is a lot more going on in deriving a valuation of a medical practice.