If you are an owner, either in part or in whole, of a medical practice, you may want to know the practice's value as of a certain point in time. Divorce, shareholder disputes and bankruptcy are a few situations that require the medical practice's value be determined. The value to be calculated is called fair market value. Fair market value is defined in IRS Revenue Ruling 59-60 as the amount at which property would change hands between a willing buyer and a willing seller, each having reasonable knowledge of the relevant facts and neither being under any compulsion to buy or sell. The valuation method most often used to determine fair market value of a medical practice is called the excess earnings approach.
- Skill level:
- Moderately Challenging
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Things you need
- Medical practice's balance sheet as of the valuation date
- Medical practice's historical income statements for the past three years
Determine the date to be used for the valuation of the practice. If the valuation is being prepared for a divorce, shareholder dispute or bankruptcy, the court will set the valuation date.
Determine whether adjustments need to be made to the amounts reported on the practice's balance sheet. For example, accounts receivable may include bad debt that must be written off. If the practice owns the building where it is located, a real estate appraiser must appraise the building to ascertain its current market value. An adjustment will then need to be made to show the building at market value instead of book value, which is the purchase price minus depreciation. Verify that all liabilities are accurately reported on the balance sheet. If there are loans or notes payable among the liabilities, record them at the outstanding principal balance as of the valuation date.
Calculate the value of the practice's net tangible assets by subtracting the total adjusted liabilities from the total adjusted assets as of the valuation date.
Determine the practice's normalised cash flow using the historical income statements. For each year, add back in officers' compensation, nonrecurring expenses, depreciation and noncompulsory expenses. Calculate the average normalised cash flow and determine whether the result is reasonable based on the practice's performance.
Subtract reasonable officers' compensation from the average normalised cash flow determined in Step 4. Reasonable officers' compensation can be found by searching databases online or researching medical journal studies. This figure represents the practice's normalised cash flow after officers' compensation.
Calculate the reasonable return on net tangible assets. To do this, multiply the net tangible assets calculated in Step 3 by the rate of return associated with those assets. A good rule of thumb is the rate at which the practice borrows from banks.
Subtract the return on net tangible assets calculated in Step 6 from the normalised cash flow calculated in Step 5. This represents pre-tax excess earnings.
Multiply the pre-tax excess earnings found in Step 7 by 40 per cent to calculate the practice's after-tax excess earnings.
Calculate the good will of the practice by multiplying the practice's after-tax excess earnings by the appropriate multiple. For medical practices, the multiple can range anywhere from 1.0 to 5.0, depending on the revenues of the practice, the number of physicians and the annual net profit generated. The greater these factors, the greater the multiple should be. For example, a practice with revenues of £3 million, generating profit of £1.0 million (30 per cent of revenue) that has five doctors on staff will use a greater multiple than a practice with revenues of £422,500, generating profit of £97,500 (23 per cent of revenues) that has two doctors on staff.
Add the good will calculated in Step 9 and the net tangible assets calculated in Step 3. This represents the fair market value of the medical practice as of the valuation date, before discounts or premiums.
Determine whether discounts are necessary in the valuation. Discounts can include the key man discount, discount for lack of control and discount for lack of marketability. Discounts require many hours of study to understand and apply correctly, and each discount should be supported by data recognised by local and national courts.
Calculate Fair Market Value
Tips and warnings
- It should be noted that there are three acceptable valuation approaches, each with its own methods. The three valuation approaches are the income approach, the market approach and the cost approach. This article covers using the excess earnings method, which is a method under the income approach to valuation. The market approach to valuation may be used in the case of a large medical practice if data can be found for the sale of similar medical practices. Generally, the cost approach is not used to value a medical practice because a medical practice is a service-based company, not an asset-based company.
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