Before we get too mired in the details of practice valuation, I want you to do something, real quick.
If you're considering selling your practice:
Off the top of your head, what do you feel your practice is worth? What do you think you deserve?
If you’re considering buying a practice:
Knowing what you know, what does you gut say the practice is worth? Not “how much can I afford,” but how much do you believe it is worth?
Keep those numbers handy as you read through this article.
In the process of researching medical practice valuation, you are likely to find that there are a number of “experts” out there who will tell you that they have a formula they use related to your income and expenses, and they may try to make the process opaque.
They’ll tell you that they have special certifications and patented methods that they would be happy to reveal and print up and put in a binder with your picture on it after you pay them a retainer.
But let’s get right to the truth of the matter.:
The true value of a practice is not the amount you think it is worth, nor the amount someone tells you it’s worth based on gross, net, multipliers and the like. Rather, it's how much someone is willing to pay.
There are many methods to consider in fleshing out the value of your practice. Some of the most common include:
Years ago, I ran and later sold one of the first medical billing and practice management software companies. At the time of the sale, there was this idea that one could value a company at anywhere from 1.5 to 3x the gross annual revenue of the business. And that’s what we did. The "1.5-3x" is the multiplier.
The rule of thumb method of practice valuation is a simplified approach used to estimate the value of a professional practice or business. It involves applying a predetermined multiple to a financial metric, typically the practice's annual revenue or earnings. The specific multiple used depends on the industry, location, and other factors. For example, in the medical field, the rule of thumb might suggest using a multiple of 0.5 to 1.5 times the annual gross revenue. In other industries, such as accounting or legal practices, the multiple might range from 0.8 to 1.2 times the annual gross revenue or net earnings.
It's important to note that the rule of thumb method is a rough estimate and should be used cautiously. It does not take into account the unique characteristics, profitability, or growth potential of a specific practice. Therefore, it's generally considered a less accurate valuation method compared to more comprehensive approaches like the income approach, market approach, or asset-based approach. Ten or fifteen years ago, the “rule of thumb” was that the value of a practice was 1.5-2 x revenues. But, given large-scale changes in healthcare, medical billing, back-office costs, more physicians working in groups rather than solo practices, and a host of other causes, most practices tend to be sold for a price at or below their average annual revenues.
The market approach involves comparing the practice being valued to similar practices that have recently been sold in the marketplace. By analyzing comparable transactions, the market approach provides insight into the fair market value of the practice.
This is a lot like the way a house is sold: You compare your practice to what other similar practices in your area and of a similar size have sold for. You find “comparables” (comps). The thing is, there is no generally recognized source of medical practice comps. The exception to this is where selling a building is concerned.
It's important to note that the market approach relies on the availability and reliability of relevant comparable transactions. If there are limited recent sales or the comparables are not truly similar to the subject practice, the accuracy of the valuation may be compromised. Additionally, the market approach should be used in conjunction with other valuation methods to ensure a comprehensive analysis of the practice's value.
When selling a practice along with (or without) ownership of the office itself, we have very specific ways of valuing each, together and separately, and we’d be happy to discuss these methods with you.
The income approach focuses on the future income or cash flow potential of the practice to determine its value. This approach estimates the present value of the expected future earnings or cash flows generated by the practice.
Here's how the income approach generally works:
1. Determine the appropriate income stream: Identify the income stream that best represents the practice's earning potential. This could be net income, cash flow from operations, or owner's discretionary cash flow, depending on the nature of the practice and industry norms.
2. Project future income or cash flows: Forecast the expected future income or cash flows generated by the practice over a specific period. This typically involves analyzing historical financial data, market trends, industry outlook, and other relevant factors. The projection period is usually 3 to 5 years, although it can vary depending on the circumstances.
3. Consider the risk and growth factors: Assess the risk associated with the projected income or cash flows. Factors such as market conditions, competition, regulatory environment, and practice-specific risks are taken into account. Additionally, consider the growth potential of the practice and any expected changes in revenue or profitability over time.
4. Determine the discount rate: Apply a discount rate to the projected income or cash flows to account for the time value of money and risk. The discount rate reflects the expected rate of return an investor would require for investing in the practice, considering the level of risk involved. The discount rate is typically based on industry benchmarks, market rates of return, and the specific risk profile of the practice.
5. Calculate the present value: Apply the discount rate to each projected income or cash flow figure and sum up the present values to arrive at the present value of the expected future earnings or cash flows.
6. Consider terminal value: In addition to the projected income or cash flows, the income approach often incorporates a terminal value, which estimates the value of the practice at the end of the projection period. This is typically determined using a multiple or a perpetuity formula based on a sustainable growth rate.
By combining the present value of the projected income or cash flows with the terminal value, the income approach provides an estimate of the practice's overall value.
It's important to note that the income approach requires a comprehensive analysis of financial projections, industry dynamics, and risk factors.
Using a house as an example, if you owned a house worth $100,000, but it rented at $5,000/mo, the asset (the house) is worth more than its base value of $100,000 because it also generates $5,000 per month. The higher the income stream, the more valuable the house becomes, and future earning potential (which really is goodwill) becomes part of the equation for valuing it.
While this seems an obvious, positive approach, in reality, it usually doesn’t pencil out for medical practices, as the income from a practice is produced only at the time the practitioner performs the service, and is usually taken home as “profit” as soon as it’s paid. There is no additional, residual, passive income generation from most medical practices.