Medical Practices: A BV [R.Sub.X]: Using an Income Approach to Value Health Care Practices Gets the Best Results

Article excerpt

EXECUTIVE SUMMARY

* CPA/ABVs NEED TO BE AWARE that a market-data approach to valuing medical entities is easy to follow but may yield less meaningful data than an income approach.

* INCOME-APPROACH METHODS include capitalization of cash flows (CCF) and discounted cash flow (DCF). CPA/ABVs must identify a normalized net cash flow from operations and apply a discount or capitalization rate that reflects associated risk. The purpose is to determine whether future revenue will mirror the past.

* A CPA/ABV USING THE INCOME APPROACH must identify what portion of a practice's revenues depend on Medicare, HMOs and other insurers and understand their respective fee restrictions; determine reasonable physician compensation (vis a vis goodwill); determine the correct discount rate based on the relative risk of various physician specialties; and quantify a realistic growth rate.

* THE ACCEPTED INTERPRETATION of reasonable compensation under the fair market value standard is the salary necessary to hire a nonowner replacement physician of equal experience. In other words, the CPA/ABV must distinguish between the return on labor and the return on capital or equity.

* BESIDES KNOWING THE CORRECT QUANTITATIVE assumptions to use in a valuation model, the CPA/ABV must be familiar with the key regulatory factors: the Stark laws, the Anti-Kickback Statute, the Intermediate Sanctions Provision of the Internal Revenue Code and OIG Special Advisory Bulletin, Practices of Business Consultants (June 2001).

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Valuing medical practices is full of traps. Byzantine regulations, draconian fines, piecework economics, unit fees that grow at less than the rate of inflation and a heavy reliance on personal goodwill as a key intangible asset are only some of the possible pitfalls for the CPA/ABV or other valuation analyst asked to "prescribe" a price.

Physician clients need business valuations (BV) for diverse reasons: a purchase or sale or to allocate purchase price components for tax or financial reporting purposes or for divorce or other types of litigation. CPA/ABVs considering using the market approach to value health care entities should be aware it yields less meaningful data than the income approach. This article details market-data pitfalls in medical practice valuations and offers guidance on four key aspects of using an income approach to get the best results.

FUELED BY FICTION

The physician practice management (PPM) industry boom began in the early 1990s. PPM was a new business model based on consolidating health care systems and physician practices under entrepreneurial management. A great many "roll-up" transactions replaced traditional physician-to-physician transfers of small practice units, and PPM became a large public market segment, with $13 billion in capitalization and more than 30 public companies created and grown by acquisitions. However, by the end of the decade the sector's health had declined dramatically--starved by insufficient postacquisition cash flow to support transaction prices. Most valuation analysts who used these transactions as the basis of appraisals derived multiples based on numbers of physicians "acquired" to determine price. CPA/ABVs in the current environment will want to follow a more sustainable valuation model.

One important aspect of medical-practice cash flow is that buyers of medical practices can't simply pass the acquisition price on to patients as, for instance, a restaurant does when a new owner charges customers higher prices or reduces portions. Indeed, most owner-physicians realize the bulk of the net present value of their investment through annual earnings, not from a business sale. CPA/ABVs will find that future cash flow on a stand-alone basis is the appropriate indicator of value for small, privately held medical practices.

WHY MARKET DATA ARE SUSPECT

It's easy to understand why some valuation analysts found a market approach for medical-practice BVs plausible and attractive. …