Multiple Valuation of non-Listed Enterprises From the Health Care Branch – Concept and Analysis

Table of contents

List of Abbreviations

List of Tables and Figures

1 Introduction
1.1 Problem Definition and Objectives
1.2 Course of the Investigation

2 Conceptual Framework
2.1 Underlying Assumptions and Derivation of Multiples
2.2 Categorization of Multiples
2.3 The Approach to Multiple Valuation

3 Entity Valuation of a Medium-Sized Health Care Company
3.1 The Target Company From the Health Care Branch
3.2 Key Steps of the Multiple Valuation
3.2.1 Assessment of Value Drivers
3.2.2 Identification of Comparable Companies
3.2.3 Calculation and Evaluation of Peer Group Multiples
3.2.4 Valuation of the Target
3.3 Critical Review of the Valuation

4 Conclusion

Appendixes

List of Abbreviations

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List of Tables and Figures

Table 1 Financial Figures of Target A

Table 2 Financial Figures of the Guideline Companies

Table 3 Net Debt, Equity Ratios, and Beds of the Guideline Companies

Table 4 Growth and Margins of the Guideline Companies

Table 5 Equity Value, Firm Value, and Multiples of the Guideline Companies

Table 6 Synthetic Peer Group Multiples

Table 7 Relative Valuation Errors

Table 8 Firm Value and Equity of Target A

1 Introduction

1.1 Problem Definition and Objectives

The valuation of companies is one of the key issues facing corporate finance applications today. In practical business several methods of valuation compete with each other. Aside from the discounted cash flow method, the valuation of companies with multiples is one of the most common methods used (Lie & Lie, 2002, p. 44). Thus, multiples are often used in valuations associated with leveraged buyouts, initial public offerings and other mergers, and, acquisition activities as well as the regular reporting of financial analysts (Bhojraj & Lee, 2001, pp. 407-408). Multiple valuation can be performed by valuing a target firm based on measures of comparable companies. This Comparable Company Valuation (CCV) appears to be straightforward, nevertheless, it is a non-trivial process which enables a person to obtain a sound value for a target. Although valuations using multiples is common, it is only marginally discussed in business research. Furthermore, the theoretical basis of multiples to reliably value firms is controversial (Barthel, 2007, pp. 667-668). Nevertheless, multiple valuation is a favored method through which to obtain the value of non-quoted companies. The critical point with companies not being listed at the stock exchange is the apposite valuation of non-listed equity. In addition, targets operating in a complex market environment or branch accessorily complicate the valuation. One of the most dynamic and fastest growing businesses of recent years is in the field of health care. The complexity comes mainly from the differences in regional health care systems and strong state control (Garruto and Loud, 2001, p. 79). Due to those facts, the valuation of operators of hospitals is a difficult application. The aim of this practical report is, on the one hand, to give sound insight in multiple theory and, on the other hand, to value a privately held Small- and Medium-sized Enterprise (SME) in the hospital sector using multiples.

1.2 Course of the Investigation

This paper is separated into two sections. The first section deals with the conceptual framework and, thus, shows the major underlying assumptions of multiples. Furthermore, it gives a categorization of common marked-based multiples. At the end of the conceptual framework the paper deals with the theoretical concept of a four step approach towards CCV that represents the most common approach in practice. This knowledge will pave the way for the practical section of the paper.

The practical section of this work deals with the four step model of market-based multiple valuation. After introducing a non-listed target company from the German hospital sector, a valuation will be performed. This health care company serves as a suitable example to demonstrate and evaluate the concepts and critical issues of the CCV. The first step deals with the assessment of value drivers that are meaningful for a multiple valuation of the target. Afterwards, this work deals with the composition of the individual peer group of the health care target. Researching comparable companies will be performed through the databases Dow Jones Factiva, Global Market Information Database, and Hoppenstedt Firmendatenbank as well as health care-specific stock indices like the DAXsector All Pharma & Healthcare. We will derive the financial data of the respective comparable companies from their individual financial statements. In the third step the aggregated data from the peer groups will be processed to obtain the final multiples. Based on those final multiples a valuation of the target will be performed in the forth and last step of the CCV. The results of the practical valuation will be evaluated and critically reviewed afterwards. Finally, the outcome of multiple valuation as a whole as well as the analysis of the target valuation will be summarized in the conclusion.

2 Conceptual Framework

2.1 Underlying Assumptions and Derivation of Multiples

In practice the term multiple usually refers to accounting-based market multiples (Chan, 2009, p. 5). Thus, according to Penman (2004), a multiple can be defined as “the ratio of a market price variable to a particular value driver of a firm.” Here a value driver is a key financial figure that makes up the denominator of multiple ratios whereas the numerator of multiples usually contains the Firm Value (FV) or Equity Value (EV). Multiples are derived from companies that can be considered comparable. The theoretical justification for the use of multiples goes back to the principle of arbitrage (Meitner, 2006, p. 30). According to this principle, substitutes should be priced in an equal manner. Hence, companies that can be considered as comparable should also be priced in an equal way otherwise the principle of arbitrage would not hold and investors could buy cheaply and resell for a higher price without any risk. However, one has to regard the principle in a weakened form as there is no total equality among companies. This is the reason for assembling comparables to a peer group (Meitner, 2006, p. 32).

With respect to the definition of multiples and the underlying assumptions, the mathematical foundation of CCV can be depicted as

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where [illustration not visible in this excerpt]denotes the firm or equity value and [illustration not visible in this excerpt]denotes a particular value driver for the Target [illustration not visible in this excerpt]and the comparable company[illustration not visible in this excerpt] at time[illustration not visible in this excerpt] (Böcking & Nowak, 1999, p. 170). Unlike the target, the value of the comparable firm[illustration not visible in this excerpt] can be determined as it is publicly traded. With respect to this, the multiple theory is also based on the controversial assumption that the market capitalization of a firm reflects the true value of the company’s listed equity (Buchner, 1994, p. 1575). Hence, it assumes that the capital markets are efficient and that the market fully reflects all available information at any time (Fama, 1970, p. 413). The value of the target is the only unknown variable in equation (1) which means that the equivalent equation

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yields a numerical value. The ratio [illustration not visible in this excerpt]of the respective comparable company[illustration not visible in this excerpt] is the multiple, which we will denote as [illustration not visible in this excerpt].

2.2 Categorization of Multiples

One major characteristic of CCV is its applicability to a variety of different multiples. A categorization of commonly used multiples can ease underlying decisions in the valuation process. Apart from different value drivers, multiples can be classified as either trailing or forward-looking as well as equity or firm value multiples (Hunt, 2003, pp. 62-64). Independent from that, the numerator always contains the most recent value. However, the value driver of forward-looking multiples is an analyst forecast for the next financial year of the company. Contrary to that, trailing multiples rely on recently reported figures (e.g., trailing 12 month) from the financial statement. Liu, Nissim, and Thomas (2001) proved superior performance of forward-looking multiples. However, forecasts are not available for non-listed SMEs. Therefore, all multiples used in the second section are trailing multiples.

Some suggest that it is rational to either use the equity or entity value for specific value drivers. As, for example, sales; Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA); and Earnings Before Interest and Taxes (EBIT) reflect an investment base including debt and equity, it appears more appropriate to measure these with the entity value (Liu, Nissim, & Thomas, 2001, pp. 9-10). According to this, figures that occur above the interest payments in the income statement are generally more meaningful as entity multiples. Since only shareholders claim net income in the form of dividends, earnings are normally measured with the quoted equity.

Given that numerous multiples can be derived, this work, on the one hand, surveys only on the most popular multiples used in practices which, on the other hand, proved significant practicability. The most popular value drivers are sales, EBITDA, EBIT, and earnings (Schmidbauer, 2004, pp. 151-153). These multiples outperformed, for example, cash flow-related multiples (Liu, Nissim, & Thomas, 2007, p. 66). Apart from income statement related value drivers, book value multiples are also common, for example, the Price-to-Book value (P/B) multiple. The P/B multiple is favorable for capital-intensive industries. Moreover, book value multiples do not include any performance measures (Schreiner, 2007, p. 42 & 81). A different kind of multiple valuation is the method of using non-financial value drivers (Barthel, 2007, p. 667). There are numerous kinds of such value drivers and their suitability usually depends on industry- and target-specific characteristics. With respect to the health care branch, a very popular multiple is the FV/beds multiple for hospitals (Garruto & Loud, 2001, pp. 85-86).

2.3 The Approach to Multiple Valuation

In the following pages a standard approach for multiple valuation will be introduced. The paper solely focuses on the already introduced CCV method. There are also other valuation methods using multiples like the comparable transaction valuation or the comparable industry transaction valuation (Kaplan & Ruback, 1995, p. 1067). However, dealing with several multiple methods would go beyond the scope of this work. The CCV using multiples is a multi-step process as it does not only include the pure calculation of multiples and the valuation of the target, it also includes the identification of peer companies that appear comparable to the target firm. These steps can be considered key success factors while, at the same time, they are the most sophisticated and controversial steps in the whole CCV process (Herrmann & Richter, 2003, p. 196). Surprisingly enough, this specific part of the CCV is least covered in academic research (Bhojraj & Lee, 2001, p. 408).

A four step approach is very common in practice and includes the assessment of value relevant measures, the identification of peer companies, the calculation of peer group multiples, and the valuation of the target firm (Schreiner, 2007, pp. 49-53). The first step concentrates on the selection of relevant value drivers for a CCV. This requires a thorough understanding of the target firm’s financials and operations in order to determine what value drivers are most suitable for the valuation according to financial figures, capital structure, and industry characteristics (Böcking & Nowak, 1999, p. 171). In the second step a series of comparable companies have to be selected. This part of the CCV process is the most subjective as the identification and selection of potential peers happens within the discretion of the practitioner (Lie & Lie, 2002, p. 47). According to Kaplan and Ruback (1995) companies can be considered as comparable if they are similar in their operating activity as well as their financial characteristics. There are several factors which play a role when deciding if a company is comparable to its target. These factors include similarity in their industry, business model, products or services, location, size, growth, operating margins, capital structure and risk (Böcking & Nowak, 1999, p. 171; Hunt, 2003, p. 61). The range of characteristics takes into account the fact that companies are not perfectly equal and, thus, the valuation requires a peer group of comparable firms. A peer group of between four and eight companies is optimal while two and ten comparables mark the minimal and maximal thresholds (Schreiner, 2007, p. 72). Practitioners face limitations in finding companies that are comparable with respect to all the above mentioned characteristics. One simple limitation is the number of available listed companies. Moreover, companies increasingly tend to diversify their business by operating in more than one scope of practice (Buchner, 1994, p. 1576). Consequently, the limited availability of potential peers causes loosen the research requirements. Furthermore, the selection of peers happens to a high degree based on the practitioner’s subjective evaluation. Although research studies have attempted to overcome this subjectivity by choosing comparables not on the basis of industry but on measurable similarities in capital and financial figures, the industry and operations play a major role in practical research on comparables (Herrmann & Richter, 2003, p. 210).

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