Imaging centers located on or off hospital campuses have played a vital role in outpatient radiology for decades. Ownership varies from local radiology practices or joint ventures to regional and national networks. The networks are either publicly traded or privately held companies.

Local and regional networks that are privately owned face a challenge, when changing ownership, in determining market value. The valuation will stem from a buyout of a retiring practice member or joint-venture partner, or the sale of the facility to an unrelated entity.

A firm specializing in appraisal of business ventures should perform the valuation. However, very few concentrate on just imaging facilities. There are not enough sales to support their efforts. The techniques for appraisal are somewhat standardized, but it is not an exact science. This article will describe fundamental tests that support estimates of a value. Mathematics inevitably comes into play because of the financial nature of the work. The online version of this article, which can be accessed at , contains a case study that illustrates some valuation techniques.

When valuing closely held businesses, appraisers are guided by Internal Revenue Service Revenue Ruling 59-60 as to methodology. Section 2.02 reiterates provisions in tax code pertaining to Estate and Gift tax regulations: “Fair market value is the price at which the property would change hands between a willing buyer and a willing seller when the former is not under compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts.”

Section 4 details all factors to consider in settling on a value:

. the nature of the business and history of the enterprise from its inception;

. the economic outlook in general and the conditions and outlook of the specific industry in particular;

. the book value of the stock and financial condition of business;

. the earning capacity of the company/partnership;

. the dividend-paying capacity;

. whether or not the enterprise has goodwill or other intangible value;

. prior sales of the stock and the size of the block of stock to be valued; and

. the market price of stocks and the sizes of the corporations engaged in the same or a similar line of business having their stocks actively traded on an exchange or over-the-counter market.

Three Valuation Methods

These factors require three approaches to valuation:

The Cost Approach . This begins a current balance sheet, reflecting a listing of the assets that produce income. This provides a book value for the entity. The tax code dictates the speed with which imaging and business equipment and site improvements depreciate. The resulting net value may be very different from the market value of the used equipment and improvements (higher or lower). Some of the more sophisticated firms, with national networks, assume complete replacement of the critical imaging devices based on their age. This implies a comparison of balance sheets based on an inventory of the assets:

. Current book value

. Book value adjusted for the market value of the used equipment

The cost approach is useful in a marginal facility where the only value comes from the assets because little or no operating profit is historically evident. However, a buyer might pay a premium for different reasons. A hospital may be seeking a presence in the area to capture more patients into its network, or it wishes to eliminate a competitor that is drawing cases that it wishes to redirect to another facility. The purchased facility phases out, and patients are redirected to a busier site where the incremental cases are more profitable.

A national network might pay a premium if it is more aggressive in cost control and marketing, and it seeks presence in the market. Acquiring an existing site, even an unprofitable one, might be cheaper than building a new one. This is especially true in states that require justification for addition of medical services. This documentation process can be expensive.

The Market Approach . The theory behind this analysis is that the value of a closely held business can be determined by what investors are paying for publicly traded companies. Appraisers are skilled at using the immense databases, maintained by the rating companies (Moody’s, Standard & Poor’s, Value Line, First Call, Mergerstat, et al) to identify firms in the health care sector, and more specifically those in medical testing.

Seldom will the matches be a perfect fit; most companies will be much larger or they may have multiple service lines, including testing. The appraiser is interested more in ratios and multiples than absolute dollars. The organization of the market databases allows a researcher/investor to compare performance and structure characteristics of the firms in each market sector. Below is a representative sampling of ratios and multiples often used in the comparisons:

A. Profitability . Measures ability to earn return on sales, total assets, and invested capital.

1. Profit margin=Net income/Sales

2. Return on assets=Profit margin x (Sales/Total assets)

3. Return on equity=Return on assets/ Equity

4. EBITDA on equity=Earnings before interest, taxes, depreciation, and amortization/Equity

B. Asset Utilization Ratios . Measures how productive the fixed assets are in generating cash income.

1. Fixed asset turnover=Sales/Fixed assets

2. Total asset turnover=Sales/Total assets

3. Working capital turnover= Sales/Average working capital

4. Depreciation/Sales

5. Capital asset expenditures/Sales

C. Liquidity Ratios . Measures ability to pay off short-term obligations as they become due.

1. Current ratio=Current assets/Current liabilities

2. Quick ratio=(Current assets-Inventories)/Current liabilities

D. Debt Utilization or Leveraging Ratios . Measures the prudence of debt management policies.

1. Debt to total assets=Total debt/Total assets

2. Total liabilities to net worth=Liabilities/Net worth

The Income Approach . This calculation is the principal test, and it is the opinion of this author that the market approach is a validation of this process. The explanation requires discussion of forecasting, use of a relevant discount rate, and present value.

The forecast technique commonly used by appraisers draws on actual operating results for a minimum of 3 years, where the information is constructed to offer proportions of critical operating results, generally percentages of gross income. The goal is to predict debt-free, after-tax cash flow for 5 years, then use the fifth year to account for operations beyond that period.

If the budget for valuation allows, my preference is to consider the interrelationship between examination volumes and fixed and variable expenses. There is considerable industry information concerning technician/administrative staffing based on volume. Throughput information helps to predict when incremental volumes trigger equipment acquisition, and knowledge of facility layout enables the forecaster to estimate if space is adequate. Variable cost for medical supplies is well documented. These points, however, are the perspective of an insider. Generally the appraiser is not expected to understand the operational details of the facility and uses time-honored, textbook methodology.

Table 1. A step-down of the present value calculation.

An acceptable discount rate, used in the present value calculation, can be as subjective as the forecast. Any college textbook on financial management will include a chapter on cost of capital, and appraisers draw upon the formulas to validate their discount rates. It represents the overall cost of financing to a firm (debt, and preferred and common stock), and is normally the discount rate used in analyzing an investment.

A weighting process considers the proportion of debt/equity that a firm uses to operate. Market information is readily available on the average proportions for companies in a market segment. Cost of debt capital uses high-grade corporate bonds, adjusted for the smaller size of this specific market segment. The cost of equity capital uses the Capital Asset Pricing Model (CAPM). Table 1 (page 32) is a step-down of what the calculation looks like, using rounded numbers. The discount rate is incorporated into the present value formula:

Future value/(1+discount rate)^Time period

[The symbol ^ is used in Excel to denote a mechanism for raising a number to a certain power, in this case corresponding to the time period.]

The future value is the predicted cash flow in each of 5 years of the forecast, and the time period should use a midyear convention. Most appraisal models use end-of-year convention. This is inappropriate because it implies that 100% of the predicted income occurs only at year end instead of in monthly installments, where the midyear convention is more realistic. Table 2 (page 32) shows the factors that will be in the present value model, and illustrates the difference when using the midyear convention.

The midyear factors are from a discount rate of 16%. The fifth year factor will be applied to the capitalization of the residual projection. The mathematics of the residual value starts with an assumed annual growth rate beyond the fifth year, a subjective judgment at best. The model will use 2.50%. This is subtracted from the discount rate, and the result is divided into one to calculate a multiple that applies to the residual projection. This is the same as projecting the sixth year and then considering this as the annual interest on a bond paying the ADR in perpetuity.


Table 4. Benchmarks derived from the case study operating statement.

The following case study will not include an illustration of how the market approach is performed (perhaps this will be the basis for a follow-up article). But one point about the market approach is relevant to the discussion here. When the universe of publicly traded companies is chosen, the most common benchmark used in measuring value of a private venture is total capitalization (debt plus equity) divided by EBITDA. We are going to cheat a little in this illustration by first computing a value through the income approach and then dividing it by the average EBITDA of this venture to give you a sense of what the multiple is. We first begin with financial statement information that, in this case, covers 5 years (see Table 5).

Year 5 is the most recent year. Lines A to H are the operating results. Line C shows EBITDA for this venture. The reason EBITDA is a market valuation tool is that it provides gross income produced before payment of any debt, dividends, or interest. This is significant because every company goes about securing its capital and acquiring assets differently. An analyst wishes to compare the relationship between income produced from operations and the capital raised to produce it, as a measurement of efficiency.

Table 3. Operating statement for a hypothetical case study spanning five years.

Note that each component of the operating statement is also expressed as a percentage of income; this is both a forecasting technique and another type of benchmarking against market statistics. Lines I to Y show the balance sheet in dollars and as a percentage of total assets and liabilities/equity. This venture is a partnership. Line A1 is additional information about capital asset purchases in certain years. The balance sheet offers the entity book value at a point in time. The net value of the capital assets considers the original purchase price and depreciation; the actual market value of the equipment is probably different. Before continuing with the calculation of a value under the income approach, see the table of the benchmarks derived from the operating statements (Table 4).

This table of values is only part of that which a researcher would find within the massive databases of all publicly traded companies, tracked by the various firms that maintain this information for market investors. Once the appraiser chooses the universe of health care companies that match the financial characteristics of the venture, the various benchmarks you see here will be tabulated for measurement against the results of the appraised company.

Table 6 is the principle tool used in the income approach.

The gross income of line A creates the values in lines B, D, G, J, and K, where the percentages in those lines are the projection assumptions. The gross income uses a 5% growth rate, with the residual value set at 2.50% growth. Line N is the present value of the annual projection, and line P is the present value of the “Bond” that produces the line L residual amount in perpetuity at the discount rate minus the growth rate. Line S would be the value an investor would pay, minus debt service, to acquire this venture.

The average EBITDA is $4,400,000, implying that the market multiple that best fits this venture is: 19,882,000/4,400,000 = 4.5.


Table 2. Factors in the present value model using the midyear convention.

The appraiser should consider the referral patterns of the venture, and seek statistics that show how broadly based the caseload is. If a facility is dependent on a few large practices, it increases the risk because loss of one may jeopardize future income. For example, a very large referring group decides to internalize its testing rather than send patients to the facility because their caseload justifies investment in space and equipment.

Market valuation considers the fact that shareholders have a minority interest and have little influence over how a publicly traded company is run. Conversely, premiums over market are paid when control is sought (51% equity). If one joint venture partner already owns a controlling interest and seeks to buy out minority partners, he or she would expect to pay slightly less than market. Conversely, a minority holder seeking controlling interest must expect to pay more. As with almost everything in the market, there are statistics that show premium above market value that is paid to acquire a controlling interest. This can even be broken down by industry sector (health care versus all-industry). This premium is factored into the EBITDA multiples.

James A. Kieffer, MBA, is president of a management consulting business with an emphasis on radiology practice management and strategic planning. [email protected]