As a founding partner of HealthCare Appraisers and seasoned in the ambulatory surgery field, Todd J. Mello, ASA, CVA, MBA, has acquired more than 16 years of experience in valuing centers. During a presentation titled, "10 Common Mistakes in Valuing ASCs," Mr. Mello delved into commonly observed valuation mistakes of which ASC owners and operators should be aware during Becker's 14th Annual Spine, Orthopedic and Pain Management-Driven ASC Conference + The Future of Spine.
Here are 10 commonly observed valuation mistakes:
1. Failing to understand the standard of value. The appropriate standard of value in most center valuations is fair market value, and a center must understand which factors can and cannot be considered in determining fair market value. To illustrate this point, Mr. Mello provided the example of a hospital purchasing 100 percent ownership of a surgery center. During valuation, the center should not consider overlaying a hospital outpatient department's fee schedule into the valuation. Similarly, if a specific hospital gets 35 percent more reimbursement in its payer contracts, a center cannot apply this increased rate to its valuation.
"This is something the hospital brings to the table," Mr. Mello explained. "The point is we have to be careful when relying on fair market standard. It has to be of value to the hypothetical buyer (i.e., as opposed to a specific buyer)."
2. Not understanding the meaning behind the numbers. Mr. Mello explained a common mistake surgery centers and valuators make is blinding applying valuation multiples. To understand how multiples may apply to a center, an ASC should fully understand the relationship between risk and growth. Essentially, a multiple is a mathematical expression of risk and growth, which, when applied to a perpetually recurring earnings stream results in an indication of value. It is expressed as a fraction of one divided by a rate of return measuring risk minus a growth rate for the earnings stream. When you keep the rate of return constant and increase growth, a center's multiple increases. In the same way, if you maintain a constant growth rate while increasing a center's required rate of return, the multiple goes down. Additionally, centers with the same EBITDA do not necessarily have the same multiple depending on their projected growth in earnings coupled with the associated risk.
3. Incorrectly specifying the risk. If an ASC employs a third-party to conduct its valuation, the center should ensure that person understands the industry. Someone not well acquainted with the ASC business can come up with multiples that are nonsensical, said Mr. Mello.
"While market multiples can be misapplied, there is also a risk related to arriving at a nonsensical valuation conclusion," he added. "In my experience, if someone is valuing a center and comes up with an answer, if doesn't matter how fancy the font looks if that answer doesn't make sense."
4. Dealing with inexperienced valuators failing to specify OON risk. Valuators not well-versed in the ASC industry often cannot accurately assess the risk associated with ASCs operating out-of-network. Therefore, individuals attempting to value OON ASCs are either going to model that center as if it were operating in-network, thus making reimbursement assumptions, or lower the multiple on the OON cash flow. Mr. Mello also explained if a center has a reasonable timeline of when they will convert from out-of-network to in-network, the valuation is better modeled specifically into cash flows, as opposed to being built into the cost of capital.
5. Not normalizing earnings stream. At one time or another, most ASCs will experience one-time, non-recurring expenses, such as atypical legal fees and consulting fees. Such expenses may be detrimental to an ASC's earnings stream as they will inappropriately change the expense structure, said Mr. Mello.
"Valuation is a forward-looking exercise," Mr. Mello said. "What happened historically may be of interest to the valuator. However, anyone buying into the center doesn't have claims to what already has occurred. Sometimes, history predicts the future, and sometimes it doesn't."
6. Applying income-based valuation techniques when a center opens. Mr. Mello said all centers should be doing projections at a center's inception, and a center cannot forgo the importance of doing a feasibility forecast in deciding whether to proceed with the project. However, for purposes of valuing shares at inception, a surgery center should look specifically at all project costs, including build-out, equipment and working capital and then make decisions on how much of these costs will be financed with debt versus equity.
"The worst thing you can do is collect money from investors and do a capital call three months later," Mr. Mello said. "It is better to take more at the beginning."
Mr. Mello strongly advised centers to not include the prospective surgeon investor's incremental volume when pricing shares. While you can include this volume in a forecast, centers "don't want that to roll into the valuation."
7. Be wary when pricing shares for different physicians. An ASC must be very careful not to offer different physicians varying share prices based on projected contributions if they invest at the same time, as the center will be entering illegal territory. Although Mr. Mello said there is no exact definition of "the same time period," he explained that time, generally, should not surpass one year, although it may be several months or less depending on changes impacting a center's profitability, such as adding or losing physicians.
8. Failing to match invested capital and equity earning streams. ASCs should apply EBITDA multiples to invested capital earning streams, rather than equity earnings streams. ASCs must also be aware they should subtract debt from the invested capital to reach the correct equity value.
9. Thinking centers have limitless capacity. Centers have to accurately assess how many patients they can realistically serve, as this directly relates to their cash flow calculation. While ASCs often may think they have a limitless capacity, this is simply not the case based on the number of physicians, available equipment and other factors.
10. Not making other necessary valuation adjustments. Within the valuation community, there is debate over the appropriate tax rates to apply to a "flow through" entity. However, the argument does not rest in whether centers should be taxed, as Mr. Mello explained.
"It is not a debate whether you have to do it, it is a debate as to what the tax should be," he said. "The bottom line is someone pays taxes on distributions, and our benchmarks for determining costs of capital are derived from market-based rates that are calculated after-tax."
In addition, in valuing an ASC, the valuator needs to assume a “normal” level of working capital, as a center's surplus or deficit will impact a valuation.
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