One of the most problematic areas of medical practice valuation is establishing a clear understanding of the factors a valuator must assess in order to arrive at an appropriate fair market value for a medical practice. Failure by one valuator or another to understand these factors can lead to an incorrect valuation, usually an overstatement of the true value of the medical practice. The following are factors you should consider when valuing any medical practice. As a colleague once said to me, “valuation is an art and unfortunately not a science.”
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”.
Using the Wrong Assumptions in a Fair Market Value Appraisal
All (that’s 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. This method converts/discounts an anticipated benefits stream 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 valuation date. So when projecting out in to 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?
You should also look for overstated revenues as well as missing revenues. If overstated revenues are included in the calculation of practice value, the result is often on overstatement of 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) Upcoding of visit services normally due to a lack of coding education by the doctors.
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.
Finally, when making adjustments to future cash flows and expenses, you must keep in mind the 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 practice, you can increase revenues __% because you’ll now be doing these services and I don’t currently or you can eliminate $__ of expenses because you can move the practice to your location.” These are “investment” type of adjustments and should never be included in a fair market value appraisal.
Relying on the Market Approach to Value
This approach 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. It 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 you REALLY find a “comparable” sale of a medical practice today to the one which is being valued? Is the sale transaction(s) you are looking at really “apples to apples”? If you don’t think you are, don’t use it in the valuation (REMEMBER: buyers buy cash flow – i.e. the cash flow of the target medical practice).
When valuing a medical practice, you will need to assess not only these factors but many, many more. A failure to do so could have a major impact on the final valuation figure. This is arguably one of the most important parts of the valuation process and one where valuators, especially inexperienced ones, usually stub their toe.