Terminal Value - Taking the Temperature of Health Care Valuations

Terminal Value

Taking the Temperature of Health Care Valuations

Table of Contents

Abstract 3

Gordon Growth Model 4

Summary 7

References 8

Abstract

Business valuation is not just plugging numbers into formulas, but it is both a science and an art., still managed care and health care reform continue to force drastic restructuring of the health care system.

Gordon Growth Model

According to Garutto and Loud "Taking the Temperature of Health Care Valuations," the healthcare industry has undergone a significant change which affects the delivery of services, payment mechanisms, and an organization's structure." (Garutto & Loud, 2001).

Events such as ownership transition, compliance with legal and regulation, and strategic planning call for an independent appraisal of a business's capital structure; moreover CPAs perform health care evaluations to make certain clients do not manage strategic planning in isolation.

Companies seek valuation experts to obtain independent opinions of entity value, the fairness of transactions and the consequences of strategic business decisions, such as discontinuing a product line, divestitures of a division or acquiring a competitor.

Management also may seek to understand better how its value of activities allocate across different business segments and “drivers” of value, furthermore, the income, market or cost valuation approaches are the three traditional methods used to estimate stock price or organizational value.

An income approach values historical or projected revenues and evaluators use the discounted cash flow (DCF) method, and developing Pro forma financial statements, determining free cash flows, a discount rate, and calculating residual value is fundamental steps in valuation.

The market approach examines similar entities and allows the evaluator to choose either guideline methodology or merger or acquisition method.

The cost approach also called the net asset approach looks at individual asset and liability values adjusted to fair market value, and a substantial investment in tangible assets or when operating earnings are insignificant about the value of the underlying assets may prompt the use of this valuation method.

Mark O. Dietrich, CPA, ABV, of Dietrich & Wilson, PC, says, “in any valuation transaction subject to regulatory review (and most are), fair market value is almost guaranteed to be the required standard of value” (Garutto & Loud, 2001).

Getting the right data produces a report that identifies all relevant variables, states assumptions and supply's supporting calculations.

Evaluators analyze primary operating characteristics: how services provided and reimbursed, patient referral sources, service area covered, regulatory compliance, and cost containment and utilization management.

The Gordon Growth Model or Constant Growth Model is an important valuation tool used to arrive at fair value with some limitations. The time pattern can be rising, falling fluctuating randomly, or even zero, but growth cannot be larger than the discount rate or minimum acceptable return also called the required rate of return. No company is worth an infinite amount of money; therefore, growth cannot be larger than the discount rate.

The attached DCF excel spreadsheet tab illustrates the DCF method after forecast development calculation of free cash flows and discount rate decision making. The selected article forecast development projects operating cash flows (including last year) to price residual value of a hypothetical healthcare organization.

Terminal value (continuing or horizon value) is the present value at a future point in time of all future cash flows where you project stable growth forever.

Residual