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Valuing in Troubled Waters is not Plain Sailing

A recent exchange with the chairman of a large care home group has thrown up some interesting questions in respect of valuation methodology

Troubled waters

A recent exchange of dialogue with the respected chairman of a large, well run care home group has thrown up some interesting questions in respect of valuation methodology in a time of lower values.

The scenario is that we are discussing his company’s potential offer for a group of purpose built, fully compliant homes. The assets are not brand new, but they are modern - predominantly post 2000 - and accommodation is entirely in single, en-suite rooms. The current management has had some specific issues which have led to occupancy being below both national and regional bench-marks, however the group operates profitably nonetheless. In the course of our discussions regarding what price the group may achieve, I use the expression “price per bed” to illustrate what that may ultimately be.

The response, perhaps understandably, is for me to be robustly reminded that we are in an earnings-multiple valuation arena now and that the market can no longer value on a price per bed basis. The homes in question are not all in the most affluent areas and interestingly, it is also suggested that as the location will undoubtedly affect the earnings potential of the assets, the multiple applied should also be lower. There are two, or possibly three, specific points raised here which are worthy of closer analysis.

The first is the question of price per bed. I would agree entirely that valuers should no longer appraise care homes solely on this basis, but equally I don’t believe they ever have. Price per bed should be, and to my mind has been, used as a sense-check when considering the value or price of a care home. It is a benchmarking process for our industry. In the same way that developers consider cost per square metre for building projects or those in farming assess agricultural land on a price per acre basis, so the care sector has adopted price per bed as it’s ready reckoner. It is a barometer for our sector and a useful tool for both expressing values and testing assumptions.

This was perfectly illustrated as our discussions progressed. Taking the same earnings multiple used in valuing his own group in recent months and applying it to the homes in question, I was then presented with a notional offer for the group. When the price per bed assessment was applied to the aggregate figure, it broke back to around £28,000 per bed. This, I would remind you, for fully compliant, purpose built, 100% single en-suite care homes operating in profit. My use of price per bed as a sense-check in this case suggested something was wrong.

We know that these homes are not in the most affluent areas and property values are relatively low. It may be possible to acquire land for development of a care home in a similar area at a value equivalent to, say, £7,500 per bed. Approach a developer these days and those offering the keenest price may charge you something over £50,000 per bed to provide a turn-key on your land. Factor in initial professional costs and build-up costs of operating and you can easily look at another £5,000 per bed. So in total you could spend £62,500 to provide an operational unit, not factoring in the time-costs and cost of your money during what could be an 18 month - 2 year process. We know that turn-key assets in the north have been transacting at between £65,000 - £70,000 per bed recently, which underpins these numbers. Granted, these new assets will be more “state-of-the-art” than the group in question, however this is juxtaposed by the immediate cash-flow in the existing group, a big issue for lenders in today’s market. So with the capital cost of providing the care home north of £60,000 per bed, £28,000 per bed is clearly a non-starter. When I suggested that he would not seriously expect to acquire trading assets of this quality at that figure, the chairman in question, to be fair, agreed.

So whilst price per bed should not be relied upon to value care homes, nor should (or can) the valuer rely solely on valuation multiple when assessing asset-backed businesses of this nature. The business and property have to be considered in the round. The bank and investors (or anyone) will agree that the raison d’etre of the care home as an investment (accepting this relates to financial rather than operational aspects) is to generate cash-flow and ultimately profit. Admittedly a hopeless case is a hopeless case, but where the asset base is good, cash flow exists and the inherent problems are identifiable, it is a far smaller step for the right management to take that to mature profitability than it is for them to start from scratch. There is value in the opportunity as well as value in the tangible asset, which must both be weighed in addition to simply applying a multiplier to run-rate profit.

The question of what that multiplier should be was also raised by this exchange. It was the contention of the potential buyer that as “the location will undoubtedly affect the earnings potential of the assets, the multiple applied should also be lower.” That view was arrived at because the valuers of his own group had varied the multiple ascribed to individual homes because of their location. However, there must be an element of double counting (or discounting) in this methodology. Location is key because it affects the ability to deliver profit. Where that ability is impeded or reduced as a consequence of location, then that is precisely what the profits multiplier method of valuation inherently takes into account. Assets located in an area capable of delivering high profitability will, by definition, be valued at a greater figure than equivalent assets in a less lucrative location - using the same multiplier.

To factor in an additional discount for the less profitable assets could only be soundly defended for one reason - taking the capital value of the asset into account. If that is happening, then it proves the original point that the profits multiplier method cannot and is not relied upon as the sole method of assessing value any more than is price per bed. This is never more clearly illustrated than by assets which are capable of, but not currently, performing at full potential.

Today’s market may be very different to that of two years ago, but there are a variety of factors which affect value in addition to the availability or otherwise of bank debt. More than ever before, the valuer must have the necessary experience and understanding of the sector to avoid the risk of costly miscalculation. With more forced sales and insolvencies predicted in 2010, banks and insolvency practitioners should pay heed.

Ian C Wilkie

February 2010