5 Fundamentals for a Physician Practice Valuation

In order to coordinate care, many hospitals and health systems are acquiring physician practices. A key step in the process is the valuation of the practice. The valuation is a conclusion on how much a physician practice is worth. To determine the value, tangible and intangible components are considered. Tangible components are the hard assets of a practice such as working capital, furniture, fixtures and equipment. Examples of the intangible assets are a trained workforce, trademarks, medical records, trade name and contracts.

There are three accepted methodologies for valuing a physician practice: the income approach, the market approach and the cost approach. All three approaches look at the value of intangible and tangible assets. Yet, each approach is distinct and can result in different value conclusions.

"Although not all three approaches are typically utilized in the ultimate value determination of a physician practice, it is fundamentally sound for an appraiser to utilize all three methodologies in the process," says Clinton Flume, manager at VMG Health. "An appraiser should be able to provide support for the selection and weighting of the methodologies employed."

In addition, two other components can affect the valuation of a practice: physician compensation and goodwill. Healthcare executives and physicians interested in streamlining an acquisition process could benefit from knowledge of the three valuation approaches as well as how physician compensation and goodwill play a role.

Physician compensation
Although all three approaches assess the value of a physician practice under different methodologies, they all require an understanding of physician compensation. According to Mr. Flume, when assessing the value of a physician practice, the projected physician compensation is the most crucial element to guarantee that an acquiring or purchasing organization receives the value they expect.

"Understanding historical physician compensation can provide an appraiser a starting point in estimating projected physician compensation. However, it is critical to have input from the buyer of the practice to make an ultimate determination of go-forward compensation. As is the case with most physician practices, if a physician is compensated at or above their historical earnings — of compensation plus distribution — there is generally limited available cash flow for a willing buyer to generate a return," says Mr. Flume.

A potential buyer will want to know the level of earnings the practice creates and how much of the available earnings are applied to a physicians' compensation. "If you do not have the correct projected compensation for a physician, the valuation of the entire practice could result in a false value," says Mr. Flume.

Goodwill

Another question that often arises is related to how goodwill is valued as part of the valuation. Many physicians think of goodwill as a brand, local reputation or community involvement. While those may be contributing elements to goodwill, appraisers will use other formulaic methods to determine the level of goodwill for a business enterprise. The goodwill of a practice is the remaining value after intangible and tangible assets are identified. Goodwill is evidenced by a source of cash flow for a practice that cannot be explained or attributed to other assets or is not a separable part of the practice.

"All else being equal, the higher the value of the business, the higher the calculated goodwill will be. Similarly, the higher the amount of the value ascribed to the hard assets such as working capital, furniture, fixtures and equipment, the lower the calculated goodwill will be," says Chris Gauvin, manager at VMG Health.

"The level of goodwill can vary significantly from business to business based upon the unique factors of the subject company. For instance, just because a practice has goodwill through community involvement, returning patients or a strong reputation does not mean there will be future profits associated with the practice. If the business is not operated efficiently, you may not have the cash flow to support a high level of goodwill, and this indicates an opportunity for improvement," says Mr. Gauvin.

Three Approaches


1. Income approach. The income approach, like its name, estimates the future income or cash flow of a physician practice. "To determine the available cash flow of the practice, an appraiser can construct a cash flow projection commonly referred to as a proforma. The proforma serves as a valuation firm's best estimate of the projected revenue, expenses and available earnings of the practice," says Mr. Flume. Once the available cash flows of the business are determined, they are discounted back to the present. Within this type of valuation, physician compensation plays a vital role in determining the available cash flow of the practice. One of the benefits in constructing a proforma is that it summarizes the historical operating performance of the practice and projects future earnings. This is beneficial to hospital executives because they receive a projection of the future cash flows of the physician practice. According to Mr. Flume, both historical and projected practice performance can be compared across multiple periods to give the appraiser a view of the growth, decline and stability of the practice.

2. Cost approach. The cost approach estimates the value of a practice by considering the costs required to recreate the practice. "In layman's terms, this approach looks at the value of the practice as the associated cost to produce or replace the assets of the business," says Mr. Flume. This approach typically delineates the practice's tangible and identifiable intangible assets. The tangible assets include fixed assets and working capital and will generally serve as a base for the valuation of a physician practice." In terms of the value of the fixed assets, VMG Health typically employs a valuation methodology that identifies the current market value of the assets. Ultimately, the acquirer of the practice will pay a current market value of the practice assets plus any identifiable intangible assets. In terms of working capital, the decision whether or include this amount in the purchase price should be discussed between buyer and seller.  

3. Market approach. Lastly, the market approach estimates the value of a practice by comparing similar businesses to the physician practice in the market. "Due to the fact that physician acquisitions are rarely published in the public domain and specific transaction data, such as terms of acquisition, is not readily available, the market approach is typically not as useful of a methodology in assessing the value of a physician practice," says Mr. Flume. Furthermore, the unique and defined circumstances that surround the operations and acquisition of each physician practice makes comparison across the industry difficult. For instance, physician compensation is one issue that makes it difficult to value a physician practice utilizing the market approach. Physician compensation structures such as base compensation, performance incentives and length of employment can vary widely between acquisitions, which is a significant limiting factor in utilizing the market approach.

Despite the lack of applicability of the market approach, all three approaches are considered to determine the ultimate value of a practice. Although the market approach is not used by appraisers as often as income or cost approach, within a physician practice setting, it is still important to understand all three methodologies.

The transaction process can be complicated and delayed when it is not clear to all parties how key components such as physician compensation and intangibles assets including goodwill fit into the different approaches and ultimately into the valuation conclusion. For this reason, any party in the acquisition that can explain the process or the methodologies to physicians or other officials will greatly streamline the valuation and, in turn the acquisition.

More Articles on Hospital-Physician Relationships:

How Hospitals Can Maximize Revenue From Their Physician Networks
How to Avoid Mistakes in a Physician Acquisition: Q&A With Chris Gauvin of VMG Health
Factors Driving Hospital Valuation: Q&A with Colin McDermott of VMG Health

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