At the 10th Annual Orthopedic, Spine and Pain Management-Driven ASC Conference in Chicago on June 15, Jason Ruchaber, CFA, ASA, partner, HealthCare Appraisers shared the real meaning behind valuation multiples to educate the audience and move understanding beyond the myth of the multiple.
Mr. Ruchaber began his presentation by reminding the audience that a valuation "multiple" is calculated value derived from market transactions, where the negotiated purchase price is divided by some measure of earnings. "By observing transactions, valuation multiples can also serve as a rule of thumb to establish general 'market multiples' for pricing transactions," says Mr. Ruchaber. It is important to remember that a multiple cannot be applied to a subject interest as a method of valuation without an understanding of the math and financial theory behind the multiple.
To illustrate his point, Mr. Ruchaber took the audience through a multiple equation based on its definition. Key components of the valuation multiple, and its equation, are definition of earning stream; estimation of risk measured as a rate of return; and an estimate of the rate of earnings growth. "For example, next year's earnings are expected to be $100. Thereafter earnings are expected to grow five percent per year. If the risk justifies a 15 percent rate of return, the multiple will be 10.0x. But, a 10.0x multiple of what?" asked Mr. Ruchaber.
Typically, multiples are measured as earnings before interest taxes and depreciation or EBITDA, but they can also be stated as cash flow, net income or distributions. A multiple can be the EBITDA over the most recent year, the trailing twelve months or a 2-year average. "The appropriate measure is the one that is most indicative of future earnings capacity," said Mr. Ruchaber. "In some instances, historical earnings measures must be normalized to remove the effect of non-recurring income and/or expense items," he said. The key point Mr. Ruchaber emphasized was that multiples derived from market data must be applied to the subject entity using the same measure of earnings.
Mr. Ruchaber then moved the estimation of risk, another element of market multiples. Risk is defined as the degree of uncertainty as to the realization of investment returns while risk is measured as the required rate of return necessary for an investor to commit funds given alternative investments, according to Mr. Ruchaber. "It is very important to match the risk to the measure of earnings being multiplied. For mature in-network ASCs the required rate of return is generally in the range of 18 to 22 percent; however, this can be significantly different if earnings are volatile or at risk," said Mr. Ruchaber.
A valuation multiple is a "perpetual" valuation model, and because of this, there are limitations regarding the growth assumption that can be built into a multiple. The growth assumption should generally not exceed the rate of the overall economy. "Because of this limitation, valuation multiples should only be applied to stable businesses," he said.
Mr. Ruchaber closed his presentation by summarizing the three key components of a multiple:
1. Earnings stream. "The next time you hear that Dr. Jones sold his interest for 5x, ask yourself '5x what?' Most cases the answer is 5x EBITDA less debt," said Mr. Ruchaber.
2. Risk. Mr. Ruchaber emphasized that not all earnings are the same. "Two ASCs with $2 million of earnings may have completely different risk profiles and higher risk equals a lower multiple," said Mr. Ruchaber.
3. Growth. All things equal, a higher potential for growth should equal a higher multiple.