Can you Change a Company’s Value by Measuring it? How bad valuations can destroy company value

In a classic scene from Futurama, the Professor and his team hit the racetrack where they are watching the last furlough of a horse race.

“It’s a dead heat,” booms the announcer over the loudspeaker as the screen flashes to two scientists looking through a giant device. “They’re checking the Electron Microscope… and the winner is in a quantum finish… number 3.”

“No Fair!” Growls the professor as he clutches his losing ticket “You changed the Outcome by Measuring it!”

For Quantum Mechanics, measuring something may change it. For most things in life, it shouldn’t – including an ASC Valuation. A valuation firm should tell you the estimated value of a company, or more accurately, a valuation range, but this shouldn’t interfere with the value of the company itself. The valuation company is supposed to be a referee, adjudicating impartially and allowing for a regulatory box check, not some type of 12th man coming down from the stands and entering the game.

So, stepping back for a second, why does an ASC need a valuation?

Valuation companies will point to two main reasons:

1)      To present a fair valuation for potential buyers, and to support the ASC’s worth

2)      To assure both parties that the valuation falls within ‘Fair Market Value’ and does not reflect any type of inducement that might fall afoul of the Anti-Kickback Statute

We believe that the first reason has little value or utility. When looking at acquisition opportunities we often find that the investment bank or the seller has hired a company to perform an ‘independent valuation’ of the ASC. These valuations are usually outlandish and represent more of a sales pitch than a fair valuation: profits are mysteriously forecast to rise on a business that has historically been flat, and the discount rate reflects a stable bond rather than a risky equity investment. Once the bidding process starts, any sophisticated acquiror quickly dismisses this valuation and begins their own diligence in order to establish their own valuation. In the end, it is the Market that decides fair market value, not a firm paid by the seller to perform a ‘Fair Market Value’ assessment.

The second reason for a valuation – as a regulatory check – is less exciting, but important, as ASCs are often incentivized to induce doctors to use their facility. (In many cases, a center would gladly give the equity away, even pay for doctors to take it). While Fair Market Value has an upper and lower bound, it is really the lower value that regulators are worried about, as this is where the inducements tend to occur.

The firms that perform these valuations often have limited experience as to what represents real value and how market value varies for different types of acquirers – this is something we will discuss in a subsequent article. For this article we want to address how valuation firms, often hired to perform check 2. (a regulatory FMV opinion) end up encroaching on 1. (a valuation that favors their client) and in doing so absolutely screw-up what would have been a win-win transaction. The only winner is the valuation firm who take their fee and leave a trail of destruction in their wake.  

A recent example of this is a small ASC we worked with in New York State. The one-room ASC did around two thousand cases and made around $700 thousand in annual profit. The valuation was commissioned by the owner to establish a price for an Associate who was performing cases at the center and had been offered 10% ownership.

The assessment that the valuation firm performed, (that the ASC owner paid many thousands of dollars for), valued the company at over $4.5 million or a 6.5x multiple on its profits. That means that the Associate would need to pay around $450 thousand to buy into their 10%.

So how did the valuation firm get to such a lofty valuation, and why was it so destructive?

We suspect (pure speculation, but based on significant experience) that the valuation firm likely wanted to provide a high valuation because that was what their client expected – the ASC owner wanted their Associate to pay a large amount for their 10%. Partly because it was money in the owner’s pocket, partly because owners tend to have a lot of pride around an ASC that they founded and built and want to believe that it’s very valuable.

And so, the valuation firm provided a robust (read inflated) valuation for the client – so that the client would be happy in the short term – but forgetting about the long-term consequences.  And even if this valuation worked out and the Associate did buy in, the methodology was still suspect. Valuation companies tend to over-complicate a valuation to justify their fees for something that should be simple and methodical. In this instance, the company performed FIVE different valuations and then averaged them to create final number. Even investment banks that perform fairness opinions for companies worth hundreds of millions of dollars typically only perform three, maybe four types of values: discount cash flow, sum-of-the-parts, transaction comparables and trading comparables.

In this case, three of the valuations were around $2 million (representing a 3x profit multiple, which seemed reasonable) and a third was $3.5 million. But then there were two outlier valuations: the ‘Discount Cash Flow’ and ‘Excess Earnings’ methodologies. These valuations rely on projecting future cash flows, a realm where even small tweaks to an assumption can greatly distort the valuation. For the Discounted Cash Flow, they assumed that post-tax Income would increase around 40% by year three. There wasn’t much support for this growth, but it’s not egregious. What was head scratching was how they valued the ‘Terminal Value’ at the end of year three. The terminal value makes an assumption for all future cash flows, but the further out they are, the more they are discounted, due to the time value of money, and also due to Risk. If you had a bond with the U.S. Treasury saying that they would give you $1,000 in three years you would literally bank on it – maybe at a slight discount because there will be some inflation, but you know it’s very unlikely that the government will default. But if a flaky acquaintance said he’ll give you a grand in three years for helping him move, what would you accept instead of that today, if it was certain? $200, maybe? That’s putting a discount rate of around 40% per year on it, meaning it’s highly speculative.

So, what should be the discount rate of an ASC like this be? What is the risk?

The founding doctor was near retirement. If the Associate who was offered shares didn’t accept the offer he would likely leave, crushing the center’s profitability. Then there were the usual risks: that reimbursement changed, that operations failed, that their license was revoked, and the key person risk – you have a one room three guy center. If one gets sick or leaves, you’d take a huge hit.

At the time, the risk-free rate was 4%, a bond in AT&T yielded 6.5%, and even bonds in a company such as American Airlines were yielding over 10%. So, what would be the discount rate for this ASC? Maybe 20% (a typical equity target return), 18%? 16% if you were generous? The valuation firm gave it a 6% discount rate, or 17x the year-three post-tax cash flow. For comparison, minority stakes in most single-specialty ASCs trade at 3-4x profit.

For doctors and lay people not versed in finance or valuation, the forty-page report looks robust, detailed and therefore stamped with the imprimatur of authority, but if you are able to dig a little deeper into the numbers, you find that like any narrative, it is based on assumptions. And if the assumptions are egregious, so will be the outcome. As we used to be taught in investment banking when creating financial models: ‘garbage in: garbage out’. It’s unclear what made the valuation firm decide to put such an egregious discount rate on the business’s cashflow, whether an oversight, a fudge to increase the value to please the client, or just a lack of understanding, but this careless assumption (and a similar methodology for Excess Earnings) grossly skewed the analytics, making the overall value too high… but so what?

Well, in this instance, the Associate baulked at the offer (understandably). He was offered to pay $450 thousand for a 10% stake in a company, or $70 thousand in distributions per year. It would be one thing if these distributions were assured and the Associate could go off to the beach and clip a coupon, but this Associate was at the time generating over ONE THIRD of the ASC’s revenue – he needed to work full-time for that distribution, and if he left, the center would barely be profitable. He was paying the owner in order to benefit from his own labor. After the Associate left, the center volume declined as expected and a year later it was losing money. The ‘6%’ discount rate was proven to be as absurd as it first appeared. The $4.5 million valuation (which was never real) was now significantly lower. The firm’s valuation had scuttled a promising collaboration and now the Associate would leave and have to set up his own Office Based Surgery Suite while the ASC owner was left with a money-losing ASC. In healthcare, nothing creates value more than productive partnerships, while nothing destroys value like partnerships breaking up. This breakup was unnecessary and resulted in lower profitability for each partner and duplication of healthcare facilities – two procedure rooms rather than one. There was a happy ending, however: the valuation firm got paid.