June 3, 2020
Our healthcare valuation experts have identified key areas that require the focus of U.S. healthcare executives, regulatory compliance professionals, and legal counsel in the COVID-19 environment. Here, we will discuss certain valuation principles, approaches, and methodologies that are crucial in establishing fair market value estimates that continue to be reasonable and supportable for compliance purposes. Future writings of these authors will address specific physician compensation valuation considerations and how the “new normal” will likely impact valuation assumptions.
In his book, Nassim Nicholas Taleb summarizes the characteristics of a “Black Swan” event:
“First, it is an outlier, as it lies outside the realm of regular expectations, because nothing in the past can convincingly point to its possibility. Second, it carries an extreme ‘impact.’ Third, in spite of its outlier status, human nature makes us concoct explanations for its occurrence after the fact, making it explainable and predictable.”
It is undeniable that estimating fair market value after such an event, and the associated economic disruption, has become challenging. The COVID-19 pandemic has had an unprecedented impact on the world’s economy. Unlike recent cyclical economic downturns (i.e., the Great Financial Crisis), the healthcare industry has been significantly impacted under prevailing circumstance. The financial and operational strains present for many healthcare providers prior to the outbreak have been accelerated and further exacerbated by the necessary response to a global health crisis.
The pandemic has had an adverse impact across most sectors of healthcare providers. As can be seen below, the healthcare services sector has tracked with the declines in the equity market overall (as represented by the S&P 500). In fact, the healthcare services sector has suffered a larger decline since mid-March when the virus was declared a national emergency and tracked below the S&P 500 throughout April.
Source: S&P CapitalIQ
Impact on Healthcare Providers
The COVID-19 pandemic has reverberated and disrupted the entire healthcare provider ecosystem. The hospital industry, already financially strained by reimbursement pressures and mounting costs of care, is being overwhelmed by the cessation of non-essential services coupled with the surging costs of providing care for COVID-19 patients. The stoppage of all elective procedures has had severe negative effects on hospital profitability. The American Hospital Association estimates over $200 billion in losses for hospitals over just a four-month period from March to June 2020. Many hospitals will not be able to withstand these types of losses, which will further accelerate the recent trend of consolidation in the hospital industry.
Outpatient providers, such as ambulatory surgery centers (ASCs) and diagnostic imaging centers, experienced a sudden halt in their businesses. Though some states are starting to reopen non-essential medical services including elective surgeries, it remains to be seen when (and if) the patients are willing to return and if their payer status remains the same. This is likely to be highly dependent on geography and provider type, but some outpatient providers may have sizable patient backlog immediately after reopening, while others may not see significant volumes for months. The valuator must consider the possibility of a period of non-sustainable hypergrowth in the revenue forecast as an entity works through pent-up patient backlog.
Additionally, most primary physician practices, a referral source for ASCs and imaging centers, have also been closed; therefore, the existing patient backlog may only generate volumes for a limited time until the physician practice referral streams restart. Many of these practices, particularly ones with weak balance sheets, will likely merge, be acquired, or fold.
Conversely, those providers with a strong telemedicine infrastructure will likely be more desirable and could command higher valuation multiples. Historically, there have been many legal and regulatory hurdles in the U.S. that have stymied the growth of telemedicine. Recently enacted law has temporarily waived certain Medicare restrictions on reimbursement for telehealth services, which could pave the way for further expansion of telemedicine services. The quarantine has opened the eyes of many patients and providers to the convenience and benefits of telemedicine, including the easing of overcapacity, the ability to receive care while still practicing social distancing, and increasing access to care. Telemedicine has been on the rise in recent years and widespread adoption is expected to accelerate.
Finally, an evolving issue is how this shutdown will impact physician compensation. Many physicians are compensated on a productivity basis and reduced productivity during the shutdown, as well as during the recovery period (the length of which is unknown and virtually impossible to predict), will dramatically impair compensation.
Key Healthcare Valuation Implications
Consistent with other “Black Swan” events like the “dot com” crash, 9/11 attacks, and 2008 financial crisis, the current pandemic has certainly created additional complexities when estimating fair market value. However, the fundamental principles of business valuation have not changed. At its core, valuation is a forward-looking exercise. The value of any business or asset is derived by the projected future cash flows that it can generate for the owner, the timing of those cash flows, and an adjustment reflecting the uncertainty or risk associated with those cash flows.
Although estimating the value of a business or asset has always contained an element of uncertainty, periods of sudden economic downturn and a sharp rise in market volatility increase these uncertainties and risks – especially when the magnitude and duration of the downturn are still unknown. Will the recovery resemble a “V”, “U”, “W”, or an “L + ramp-up” shape? It is during times of heightened uncertainty and potential impact on these areas that we find it useful to revisit certain key valuation foundational principles.
Next, we focus on four areas that warrant special attention:
- Premise of Value
- Valuation Date
- Valuation Approaches and Methodology
Is the Premise of Value Appropriate?
In the healthcare industry, most understand and focus on the importance of fair market value as the standard of value for regulatory compliance. A concept that garners less attention is the premise of value. Various premises of value may be considered under the fair market value standard of value. In general, four premises of value are typically considered:
Value-in-Continued Use, as Part of a Going Concern
Value in continued use, as a mass assemblage of income producing assets, and as a going concern business enterprise.
Value-in-Place, as Part of a Mass Assemblage of Assets
Value-in-place, as part of a mass assemblage of assets, but not in current use in the production of income, and not as a going-concern business enterprise
Value-in-Exchange, in an Orderly Disposition
Value-in-exchange, on a piecemeal basis (not part of a mass assemblage of assets), as part of an orderly disposition. This premise contemplates that all the assets of the business enterprise will be sold individually and that they will enjoy normal exposure to their appropriate secondary market.
Value-in-Exchange, in a Forced Liquidation
Value-in-exchange, on a piecemeal basis (not part of a mass assemblage of assets), as part of a forced liquidation. This premise contemplates that all the assets of the business enterprise will be sold individually and that they will experience less than normal exposure to their appropriate secondary market.
One could conceivably have four different fair market value conclusions depending on the selected premise of value. The selected premise of value related to a fair market valuation analysis can have material implications on the identification of assets to be valued, methodology, and key assumptions utilized. Selecting the appropriate premise of value is critical considering the impact of the COVID-19 pandemic.
Healthcare providers that were struggling financially pre-pandemic may not even reopen, particularly with the anticipated additional costs of providing healthcare services in the near-term. A question for the valuator to consider is: do we have a going concern business, or should a different premise of value be considered such as value-in-place or liquidation value? The answer has implications on the methodology and key assumptions utilized.
For example, if a value-in-place premise is assumed, the valuation of certain intangible assets may not be appropriate. In a situation where the provider business will likely close, a truncated projection reflecting a wind-down may be necessary to perform a discounted cash flow method. A probability-weighted scenario analysis assuming different premises of value could be an option in estimating fair market value.
Implications of the Valuation Date
One complicating issue that valuators are grappling with is the valuation date. While a seemingly straightforward assumption, the selection of the valuation date can become significant after a “Black Swan” event. According to valuation standards and general practice, the valuator should only consider facts that were “known or knowable” as of the valuation date. If the valuation date is prior to the impact of the COVID-19 pandemic becoming “known or knowable,” then the valuator should not consider the impact in the valuation. The key question then turns to, “When was the total shutdown from the pandemic actually a known or knowable event?” The general consensus in the valuation community appears to be early to mid-March 2020, which is when the U.S. stock market fell dramatically, and the virus was officially declared a national emergency.
Source: S&P CapitalIQ. Timeline events are sourced from (1) Secon, Holly, Woodward, Aylin, and Mosher, Dave, “A Comprehensive Timeline of the New Coronavirus Pandemic, from China’s First COVID-19 Case to the Present,” May 4, 2020 https://www.businessinsider.com/coronavirus-pandemic-timeline-history-major-events-2020-3; and (2) Hitchner, James A. and Warner, Karen A., “COVID-19: A Timeline of Significant Events, Including the Pandemic’s Effect on the U.S. Stock Market,” Valuation Products and Services, LLC.
We believe that, even if the valuation date precedes the known or knowable date and the valuation does not consider the expected financial or operational impact of the COVID-19 pandemic, the valuation report should clearly state this fact to avoid confusion. We believe this position is consistent with the guidance in the AICPA VS Section 100 Subsequent Event Toolkit.
Another complicating factor is the geographic variability of the COVID-19 pandemic’s impact. Healthcare has always been driven by the local market, demographics, and economy. However, the importance of local considerations is amplified given the wide-ranging and varied economic impact of the pandemic.
While all the states have shut down in some form, some state and local economies (and thus healthcare organizations) have been impacted to a greater degree than others. Additionally, at the writing of this article, some states have started easing the restrictions and allowed some non-essential medical procedures to resume. Now more than ever, the valuator needs to understand the local market dynamics, local and state regulations, and underlying demographics related to the healthcare entity being valued.
Market volatility and risk have certainly increased from the pandemic, and the healthcare industry has felt the brunt of this impact. With this backdrop of heightened risk and uncertainty, we will discuss some of the implications on the primary valuation methodologies, key assumptions, and considerations to help ensure that one can maintain compliant fair market valuations during these turbulent times.
Impact on Valuation Approaches and Methodologies
The three approaches to business valuation (i.e., asset, income, and market) are all predicated on future earnings streams that can be generated from a business. Under the asset approach, the business value is the price at which its assets could be sold. Under the income approach, the business value is the present value of the future earnings that can be generated from the use of its assets. Under the market approach, the stock prices of publicly traded companies or the price that an acquiror pays for a business are based upon the investor’s expectations of future earnings.
Because valuation is forward-looking, historical results and trends are only useful as a potential indicator of future earnings. Due to the impacts of COVID-19, future earnings of most healthcare businesses are going to be drastically different than historical earnings. Therefore, valuation multiples based upon historical results will not be appropriate in most cases.
The two primary methods under the Market Approach are the Comparable Transactions (CT) Method and the Guideline Public Company (GPC) Method. Under the CT Method, valuation multiples from historical completed transactions involving comparable companies are applied to the subject company. For the GPC Method, valuation multiples for publicly traded comparable companies are calculated using the public company stock prices. For both methods, comparability of the guideline transactions and companies, as well as confidence in both the numerator (price) and denominator (financial metric) are obviously important in the derivation of valuation multiples. Each of these variables will be more uncertain in a COVID-19 environment and certain earnings adjustments will have to be made.
Because healthcare is highly influenced by the local market and demographics, the market approach in healthcare valuation is often utilized as a reasonableness check to the income approach. Even within a local market, practices with different payer mixes can have widely different financial and operational characteristics. Given the COVID-19 impact, it is even more challenging to rely upon a market approach due to the scarcity of transactions and the increased need to make comparability adjustments to the healthcare provider business or asset being valued.
For the CT Method, this challenge of comparability becomes heightened during a sharp economic downturn with wide-ranging and varied local market impact. Even if transactions for comparable companies or assets can be located, these transactions occurred in the past during very different economic times and acquiring entities most likely had very different growth expectations as compared to the current market.
For the GPC Method, the valuation multiples are in part based upon the public company stock prices, that in theory should incorporate the economic downturn and resulting investor expectations. However, current stock prices may be artificially depressed and not representative of the long-term prospects for the comparable companies.
Additionally, the valuator should place more emphasis on the projected revenues and earnings of the public companies and consider calculating valuation multiples based upon those forward-looking metrics rather than last twelve-month metrics. These projected revenues and earnings would incorporate the company’s expectations considering the pandemic.
The Discounted Cash Flow (DCF) Method and the Capitalized Cash Flow (CCF) Method are the primary valuation methods under the Income Approach. Under the CCF Method, normalized earnings are capitalized into the future assuming an estimated discount rate and a constant level of growth. For the DCF Method, the projected cash flows are discounted back to a present value utilizing an estimated discount rate. Mathematically, the CCF and DCF Methods are similar, except that the CCF Method assumes a constant rate of growth whereas the DCF Method allows for variable growth rates in the short-term.
Since the CCF Method determines a value based upon a single period of earnings, the calculation of normalized earnings is critical. In these uncertain and volatile times, the amount of adjustments and normalization necessary to arrive at a single earning period considering the uncertainty related to future expected cash flow, timing of those cash flows, and risk factors would contribute to weaknesses of this methodology and likely make it impractical.
The DCF Method is often the preferred valuation method for healthcare valuation given this method is best equipped to incorporate the specific business’ expected cash flow, timing of those cash flows, and risk factors. The advantages of the DCF method becomes even more pronounced given the current and future expected uncertainty and volatility that companies face today. Earnings are projected for each discrete period in the short-term, allowing flexibility to factor in risk through the derivation of the discount rate, sensitivity analyses, and probability-weighted scenarios. During “normal” economic times, it is challenging to project a healthcare provider’s cash flows, and the pandemic further complicates the inherent complexity of valuation.
For healthcare valuations, the Asset Approach is typically glossed over, as the Income and Market Approaches more appropriately capture the value of a going concern business. However, as stated earlier, there will be more financial stress on already distressed healthcare organizations, and some healthcare provider businesses may need to be valued under a different premise of value. Therefore, in this environment there may be an increased number of valuation opinions where an Asset Approach indication of value is relied upon for the conclusion of value. This approach is generally atypical in the valuation of healthcare provider businesses and would represent a notable shift. When considering an application of the Asset Approach, some evolving issues to monitor are:
- How is the working capital of the businesses impacted by the shutdown?
- Does the business have the necessary reserves to fund the restart of operations?
- Can the business re-hire any furloughed employees?
- What is the impact on any owned facilities and/or real estate?
- Have any debt covenants been triggered and if so, can the company obtain forbearance agreements?
- Is there potential economic obsolescence related to any assets?
Estimating and supporting the fair market value of healthcare businesses and assets for compliance has always involved substantial levels of judgment. However, given the COVID-19 pandemic environment, sound judgment is even more important. This environment will require an enhanced focus by healthcare executives, regulatory compliance professionals, and legal counsel on reasonable and supportable valuation approaches, methodologies, and assumptions that reflect the specific facts and circumstances of each business or asset. Typically, straightforward valuation concepts such as the premise of value, valuation date, locality factors, and selection of the appropriate approach and methodology will now require more scrutiny and judgment.
 Taleb, Nassim Nicholas (2010) . The Black Swan: the impact of the highly improbable (2nd ed.). London: Penguin.
 “Hospitals and Health Systems Face Unprecedented Financial Pressures Due to COVID-19,” American Hospital Association, May 2020
 H.R. 6074: Coronavirus Preparedness and Response Supplemental Appropriations Act, 2020
 Shannon P. Pratt, Robert F. Reilly, and Robert P. Schweihs, Valuing Small Businesses & Professional Practices, Third Edition, 1998, pp 46-47
 “In situations in which a valuation is meaningful to the intended user beyond the valuation date, the events may be of such nature and significance as to warrant disclosure (at the option of the valuation analyst) in a separate section of the report in order to keep users informed (see paragraphs 52p, 71r, and 74). Such disclosure should clearly indicate that information regarding the events is provided for informational purposes only and does not affect the determination of value as of the specified valuation date.” (https://www.aicpa.org/interestareas/forensicandvaluation/resources/standards/aicpa-vs-section-100-subsequent-event-toolkit-coronavirus.html)