Valuations: Look at five year projected cash flow

 A. If you are purchasing the entire company, of which the bid contracts are part and parcel, then you will need to value both the existing business and the incremental cash flows the business will generate as a result of having won a bid contract(s).  

In most cases, the appropriate way to determine the potential net present value (i.e. the purchase price you may be willing to pay today for the rights to future benefits) is to look at a five-year net cash flow projection (and terminal/long term cash flows value, if applicable) of the contracted supplier's business and then discount the cash flows using an appropriate discount rate to arrive at a present value of the future business in today's terms.

This method of valuation is commonly referred to as the discounted cash flows method, or “DCF,” and allows you to factor in future events such as reductions in reimbursement rates, changes in operating structure or expense add-backs, and anticipated volume growth rates or market capture as a result of the exclusivity of the contract term.

 The net cash flows are calculated by estimating the annual net cash collections and then subtracting cash payments for equipment, supplies, delivery, service, staffing and all other overhead. You will also need to subtract cash payments for any necessary capital expenditures but should not include any non-cash expenses such as depreciation.

The discount rate (varies, but it is usually between 15%-25%) effectively quantifies the risk of those future cash flows to a potential purchaser and takes into considering the time value of money for those cash flows.

Craig Hittle is senior manager of the health care team at Somerset CPAs, PC. Reach him at chittle@somersetcpas.com or 317-472-2150.