The following is the third of three articles in a series.
Last month’s article presented a conundrum to post-acute care (PAC) facility owners in answering the critical question: What will be the impact of a perspective capital investment on our company’s enterprise value?
The conundrum as stated was, “Rarely does the company (private or public, large or small) have the internal resources to answer such as question.”
Who then can the company rely upon to advise on such matters? Larger PAC businesses generally rely on their investment bankers to perform a thorough analysis of all the alternatives. But what about owners of smaller facilities? Most smaller PACs (e.g., less than $100M in revenue) are represented by real estate brokers. Why real estate brokers? Two reasons:
a. Because a significant component of the enterprise value is generally emanates from the value of the real property.
b. Historically real estate brokers have sold PACs because the vast majority of PACs are just too small to justify the more expensive investment bankers’ resources.
Thesis
No one acquirers a post-acute care business (i.e., operations and real estate) because they like the real estate, unless the property is underutilized and the purchaser intends to repurpose the real property (for example, modifying a nursing home into an apartment building). The acquirer purchasers the assets because it wants to own the future expected free cash flow generated by the business.
The predominant valuation metric used by the vast majority of real estate brokers is called the capitalization rate, or cap rate. Conversely, the most popular valuation method used by investment bankers is a relatively complex income-based valuation method called the discount cash flow (“DCF”) methodology. In stark contrast to the capitalization rate method, which utilizes a “snapshot” picture of historical financial performance (the last 12 months operating income), the DCF method takes a “moving” picture of the anticipated future operating income, and discounts such future cash flow to the present time.
Utilizing capitalization rates have significant shortfalls over the DCF method.
Among other variables, capitalization rates do not account for leverage, the time value of money, and future cash flows from property improvements, for example. Such an assessment is a complex financial analysis and representation, which is exactly what an investment banker is trained to do when analyzing and reporting expected future cash flow variables. That stated, the property broker who has experience with PACs, generally knows how to represent components of the real property in a more effective way (e.g., floor plan, HVAC, security systems, construction type, etc.) than the investment banker.
Caution: Don’t make the mistake of utilizing one method, either the cap rate or the DCF, to value both the real estate and the business operations.
The ultimate solution
To accurately appraise the enterprise value of the PAC, one should value both the real estate and the business operations utilizing different methodologies.
The cap rate methodology is appropriate for appraising the real estate. This methodology must consider such factors as the condition of the property and its infrastructure (e.g., HVAC), the property location and demographics and the credit worthiness of the tenant (the PAC operator). The foregoing can best be accomplished by an experienced real estate appraiser.
The DCF methodology is generally most appropriate for assessing the going concern value (assuming that the value of the future free cash flow is more than the liquidation value of the non-real estate assets and that a market-based approach is not adequate, which is usually a result of a lack of comparable businesses). The DCF methodology can be complex, requiring one to make adjustments to the income statement to account for such items as owner’s compensation, fair market rent and non-recurring expenses. The accuracy of the valuation utilizing the DCF method is also dependent upon the accuracy of the forecast and the estimated cost of capital. It is commonplace for investment bankers to account for the foregoing variables.
Let’s start a discussion. Please share your thoughts.
Scott Waxler is managing director of LockeBridge Capital Partners, a leading middle market M&A Advisory and Investment Banking firm with strong credentials in Medical Device, Healthcare IT, Healthcare Facilities, and Services and Pharma/Biotech. Scott has won numerous prestigious awards including the M&A Advisor’s Deal Maker of the Year Award. For more information about Scott visit Scott Waxler Bio.
