Fair Market Value – Successful Medical Practice Valuation
By Tinsley Medical Practice Brokers
Professional medical practice valuation utilizes key factors that a qualified valuator must assess in order to arrive at an appropriate fair market value for a medical practice. Failure by an inexperienced valuator or one that does not understand these value factors can lead to an incorrect valuation, which usually results in an overstatement of true value of the medical practice. Valuation is an art that is mastered by years of experience. With over 40 years of experience, Tinsley Medical Practice Brokers are sought-after medical practice experts who help clients navigate complex financial transactions in buying and selling medical practices in Texas and across the United States.
Four Keys to Determining Fair Market Value
The following are four factors you should consider when valuing your medical practice for sale.
1) Defining Fair Market Value
According to the International Glossary of Business Valuation Terms, fair market value is defined as “The price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arms length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts.” This is the definition generally accepted in the valuation community.
Under the Stark II regulations, the following is the definition of fair market value:
“Fair market value means the value in arm’s length transactions, consistent with the general market value. “General market value’’ means the price that an asset would bring as the result of bona fide bargaining between well-informed buyers and sellers who are not otherwise in a position to generate business for the other party, or the compensation that would be included in a service agreement as the result of bona fide bargaining between well-informed parties to the agreement who are not otherwise in a position to generate business for the other party, on the date of acquisition of the asset or at the time of the service agreement. Usually, the fair market price is the price at which bona fide sales have been consummated for assets of like type, quality, and quantity in a particular market at the time of acquisition, or the compensation that has been included in bona fide service agreements with comparable terms at the time of the agreement, where the price or compensation has not been determined in any manner that takes into account the volume or value of anticipated or actual referrals.”
When valuing a medical practice, it is important to know therefore whether or not the Stark regulations come in to play. Within Stark, any arrangement must be considered “commercially reasonable” in the absence of referrals if the arrangement would make commercial sense if entered into by a reasonable entity of similar type and size and a reasonable physician (or family member or group practice) of similar scope and specialty, even if there were no potential DHS referrals.
So what does this mean if indeed the fair market value is affected by the Stark regulations?
- The Stark definition of fair market value may restrict and prevent the use of certain market comps since use of such comps may not be “commercially reasonable”;
- Just because a transaction may be “fair market value” does not necessarily make it “commercially reasonable”.
2) Wrong Assumptions in a Fair Market Value Appraisal – Future Cash Flow Versus Historical Cash Flow
All valuation is about future cash flow, not historical cash flow. This is why the Income Approach methodology is commonly used to value a medical practice. The income approach estimates future income or cash flow of a physician practice. This method converts and/or discounts an anticipated benefit streams in to a single present value amount. The valuation of a medical practice therefore relies upon risk-based assumptions as to what patients, procedures or tests will occur in the future as of the selected valuation date. When projecting out in into the future, does the volume and related expected reimbursement make sense? Is the revenue assumption too aggressive? Does it make sense to increase significantly cash flow revenues in an era of declining physician reimbursement?
Are there overstated revenues as well as missing revenues? If overstated revenues are included in the calculation of a medical practice valuation, the result is often on overstatement of total value. To reiterate, the objective is to determine the real income stream of the practice. There are often three types of overstatement situations: (a) The commitment of fraud and abuse by the practice, (b) Utilization abuse by the practice, and (c) Medical billing upcoding of medical practice services often due to a lack of current coding education by the doctors or medical practice staff.
In addition to revenues, take a hard look at the expense assumptions. Do anticipated expenses really match the anticipated revenue stream? You cannot significantly increase gross revenues without possibly adding personnel, increasing space, using additional supply costs, etc.
3) An Important Difference – Fair Market Value Adjustments Versus Investment Value Adjustments
Finally, when making adjustments to future cash flows and expenses, you must understand the important difference between fair market value adjustments and investment value adjustments (which cannot be included in the valuation). Investment value represents what a medical practice might be worth to a potential investor. As such, investment value represents individual investment requirements and opportunities; it reflects the synergies that might occur after the purchase of the medical practice. Many times a person will say “If you buy or take over this medical practice, you can increase revenues __% because you’ll now be doing these services or you can eliminate x number of $__ of expenses because you can move the medical practice to your location.” These are “investment” type of adjustments or assumptions and should never be included in a fair market value appraisal.
4) Relying on Market Approach to Value
Utilizing the market approach to medical practice appraisal is defined as a general way of determining a value indication of a business or business ownership interest using one or more methods that compare to similar businesses that have been sold. In other words, this approach calculates the value of the medical practice based on prices actually paid for comparable entities. This methodology follows the simple mathematical process of determining the sales price as a ratio to net discretionary income available for owner compensation calculated from the comparable sales data and applying these ratios to revenues of the entity being valued.
But can one really find a current, comparable medical practice sale that is an “apples to apples comparison” to the medical practice that is being appraised? Are the sale transaction(s) you are comparing true comparisons? If not, don’t use it in the valuation. An important point: medical practice buyers buy cash flow – i.e. the cash flow of the target medical practice.
When you are valuing a medical practice or conducting a medical practice appraisal, make sure you are working with experienced medical practice brokerage experts.
Above are four of many, many more important factors that must be carefully assessed when conducting a thorough review of a medical practice for sale. A failure to follow regulations and proper methodology can have a major impact on the final medical practice valuation figure. This is arguably one of the most important parts of the medical practice valuation process and one where valuators, especially those who are inexperienced, often miss the boat
Your Tinsley Medical Practice Brokers Team