In approaching the valuation of an existing surgery center, there are two distinct methods that can be used. For smaller transactions involving minority interest sales, a simple "back of the envelope" method can be employed.
This method uses actual 12 to 24 month historical EBITDA (cash flow) times industry standard multiples less long term debt to determine the equity value. Multiples range between 2.75 and 3.25 times EBITDA for minority sales and 6.5 to 7.5 times for majority interests.For larger transactions, usually the sale of a majority interest and particularly when a hospital partner is involved, a third party valuation firm is used to establish the Fair Market Value of the enterprise. These firms use three approaches to establishing the center's value.
1. Asset Value Method. For centers which are producing little or no EBITDA, value is established based on the value of the assets of the entity. This approach typically produces the lowest value and is not used frequently since sellers normally do not want to sell interest in their center when profitability is low.
2. Market Value Method. This method is based on a comparison of the entity being valued to the actual market value of similar centers or public companies with similar asset bases. Since many of the formerly public companies owning ASCs have gone private and it is difficult to get accurate information regarding the specifics of individual center sales, this method, while used much more frequently than the asset value method, has its limits.
3. Discounted Cash Flow Method. This is the approach used most commonly by third party valuation firms. It utilizes a discounted cash flow analysis, using actual historical financial statements to establish a baseline of operations. It then involves adjusting the baseline for known and projected factors to determine operating cash flow over the next five years with a projected sale at the end of the fifth year at an assumed EBITDA multiple. These cash flows are then discounted back to the present date to establish the equity value of the center.
Both the back of the envelope method and the third party valuation method use many of the same core variables to establish value. These variables include cases performed, net revenue per case, fixed and variable expenses of the center, and the center's existing level of long term debt. Both also use a multiple of EBITDA to determine the value of the center before long term debt and the discounted cash flow methodology introduces the concept of a discount rate to reduce future cash flows received to a current value.
The choice of the sales multiple and the discount rate play a very important role in establishing the final equity value. Using the back of the envelope method, if a center is producing $2M in annual EBITDA and has $1.5M in long term debt, the equity value for a 5 percent minority interest is $200,000 at a 2.75 multiple and $250,000 at a 3.25 multiple, a 25 percent swing. Similar valuation differences can exist in the discounted cash flow valuation based on both the sales multiple and the discount rate assumed in the valuation.
In addition to focusing on normal factors influencing swings in center valuation over the next few years such as number of cases, net revenue per case, costs, and debt levels, it is also important to focus on other factors which will influence the sales multiples and the discount rates applied to future cash flows. These include the growth in the number of patients who will use the newly formed insurance exchanges as their primary healthcare payment vehicle, an increase of patients using ACOs as their primary healthcare delivery source, and strategies involving partnering with large healthcare systems and utilizing their contracting power to improve reimbursements.
The newly formed insurance exchanges are expected to bring as many as 32 million new patients onto the insurance roles, hopefully reducing the usage of expensive treatment options such as emergency rooms and increasing the usage of more standard treatment sites such as surgery centers.
On the surface this situation seems positive but more careful analysis must be done to determine if these new patients will actually provide an economic benefit to a particular ASC. Are the center's surgeons currently working in areas where these new patients will be located? Is the surgery center located conveniently to these new patients? How will the exchanges compensate the center for various services provided? If the compensation is at or near current commercial rates the center could benefit from these additional cases. However, if the compensation is at or below current Medicare/Medicaid rates, after a reasonable allocation of all of the costs of providing required services, the center may actual lose money on these additional cases.
Perhaps the most significant danger is that, in geographic areas dominated by smaller employers with low margin businesses, employers may elect to drop their current medical plans and pay the penalty to move their employees into exchanges which will reimburse ASCs at low rates. If this becomes a trend in certain geographic areas, the EBITDA multiples will likely drop and discount rates will increase due to the uncertainty of future profitability and the values of these centers will certainly decrease.
The second issue which could diminish the value of a center is the percentage of patients entering ACOs. As of November 2012 it was estimated that 328 individual ACOs served 30 million patients, and the number of patients using ACOs as their primary provider increased to 43 million in February of 2013.
Combined with increasing provider consolidation as major hospital systems continue to merge, in some markets growing ACO concentration could lock up large segments of the patient base reducing the patient bases available to independent ASCs. Depending on the case mix and cost structure, an ASC that loses 10 percent of its patient base could lose 20 to 30 percent of its EBITDA, which will substantially reduce its equity valuation. Each center must analyze the ACO impact in its own market to determine if the best strategy is to remain fully independent or to join an ACO.
A potential offset to the negative impact of insurance exchanges and ACOs is to form a strategic relationship with a strong local hospital or system. This may entail joining into their ACO, selling an interest in the center to the hospital, or both. It should result in a positive economic benefit to the centers investors at the time of sale while allowing the center to gain the benefit of higher reimbursement rates through the hospitals contracting power. In many instances, net reimbursement per case can increase 25 to 33 percent under the hospital's contracting umbrella, offsetting some or all of the negative effects of insurance exchanges and ACOs.
In the current healthcare environment, nothing is certain over the next three to five years but centers that take the time to understand their individual environments and make good strategic decisions will have the best chance of protecting their long term economic value.
The article originally appeared in the Regent Surgical Health newsletter and is republished here with permission.
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