By Mark Norris
There are typically three approaches considered when valuing a physician practice – market, income and asset-based. In theory, these are very similar to the approaches that a real estate appraiser uses when appraising. Within each approach, there are multiple valuation methods. The following summarizes the more common methods used.
Market Approach
Within the market approach, the valuation method that is typically considered is the guideline transaction approach. Under this method, sales transactions of comparable physician practices are obtained from databases. Various financial data is analyzed, including balance sheet data, profit and loss data, profitability ratios (such as percentage of net income), earnings before taxes (EBT) and earnings before income taxes, interest, depreciation, and amortization (EBITDA) as a percentage of revenue. This data is compared to the subject practice.
In addition, various sales price multiples are developed by dividing the sales prices of the transactions by their respective revenue, EBITDA, EBT, and net income. These multiples are then used to develop a value for the subject practice.
The critical issue when using this valuation method is whether the practices included in the sales transactions are truly comparable. Issues regarding comparability might include:
- Geographic area
- Contracts with insurance companies
- Competition
- Type of practice
- Physical condition of office and fixed assets
- Number and type of providers
Income Approach
Within the income approach, the valuation methods typically utilized include the capitalization of earnings and the discounted cash flow methods. The capitalization of earnings method focuses on the past financial performance of the practice. In the capitalization of earnings method, five years of historical financial statements are typically reviewed. Adjustments are made to “normalize” any unusual and non-recurring transactions. One of the most important adjustments is the normalization of physician’s compensation to a market rate. Basically, the market rate of compensation should represent what would have to be paid to a non-owner physician to provide the same services the owner physician performs.
Making these adjustments produces normalized profit and loss statements for each of the years reviewed. The valuation analysts then must determine whether to average all the years’ normalized net income, average just some of the years, or utilize only one year. The overall goal is to develop a net benefit stream that represents the best estimate of what the practice will generate in the future. This after-tax benefit stream is divided by a capitalization rate to produce the value of the practice.
Asset-Based Approach
In the asset-based approach, the valuation method generally used is the adjusted net asset value method. In this technique, the assets and liabilities of the practice are adjusted to fair market value. The adjusted liabilities are subtracted from the adjusted assets to produce the adjusted net asset value for the practice.
Most physician practices maintain their financials on a cash basis. Therefore, the most common adjustment made when using this method is to record accounts receivables (after insurance adjustments), and an income tax liability applicable to the accounts receivables. In addition, the fixed assets are adjusted to fair market value based on an appraisal prepared by a machinery and equipment appraiser.
Most of the medical practices we appraise today are valued using this method because we are unable to identify comparable sales transactions in the market approach, and the practice is not profitable after normalizing owner physician compensation.
Key Take-Aways in Practice Valuation
The key points to keep in mind when valuing a practice are:
- Due to negative pressure on reimbursement rates, most physician practices are not profitable after normalizing physician compensation.
- Even if the income or market approach produces a value for the practice over and above the adjusted net asset value, the valuation analyst must consider whether this value contains personal goodwill. Any personal goodwill applicable to the owner physician will reduce the practice’s sale value, chiefly because there is a significant risk that patients will not continue coming to the practice when the current owner physician has exited.
The healthcare industry is filled with significant uncertainty today. Unfortunately, uncertainty produces risk, and risk has an inverse relationship to value. As a result, physicians should maintain realistic expectations when preparing to value and sell their practices. Using a professional valuation service can help them get a fair appraisal.
Mark W. Norris, CPA/ABV, CVA MAFF, ASA, is managing director at Chesapeake Valuation Advisors. He can be reached at mnorris@chesapeakevaluation.com.
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