How Much Is My Practice Worth? Part 3: The Income Approach
June 1, 2009

Continuing our discussion of physician practice value, we will take a look at another method that may be used to measure the value of a practice. As a refresher, the most commonly accepted approaches used in the valuation industry include:

The Market Approach

The Income Approach

The Cost Approach

This month, we are covering the Income Approach to value. The income approach measures the economic benefit yielded by a practice and translates that into a value to a prospective purchaser. This economic benefit is typically measured as the practice’s net income. The net income being considered may be based upon historical results or a projection of what is expected over the next number of years. Three to five year’s worth of net income results are normally converted into a present value for the practice.

Although this method may seem to be a straight forward and objective way to determine how much a practice is worth (at least for the accountants), there are some very important and sometimes subjective assumptions that can greatly affect the value concluded upon under the income approach. The most important of these assumptions specific to physician practice valuations involves the practice owners’ compensation and its effect on net income. Since many physician practices are structured as an S-corporation, partnership or some other type of taxable business entity it is often to the practice owners’ benefit to withdraw any taxable income as compensation, thereby paying income tax solely at the individual level as opposed to both at the business entity and individual level.

Herein lies the problem from a valuation standpoint; what is a practice worth that produces no income? A reasonable person would argue (correctly) that the value of the practice has been withdrawn for tax purposes and that the owners’ compensation represents the true worth of the practice. This is somewhat true, however consider this scenario:

Physician P owns a practice and earns $100 annually. If P offers to sell her practice to Physician E, is it worth $100 to E? No, because the value to E lies in the difference between what Physician P should be earning versus the potential $100 he could take home each year if he bought P’s practice.

Most simply stated, a physician practice has no value if there is no physician. We must consider the cost of compensation for a “comparably productive” physician when we value a practice’s income. Generally, we refer to industry benchmark compensation levels measured against such productivity indicators such as net collections for the practice or physician wRVU’s. In regard to our scenario above:
 
Physician P’s practice has produced annual net collections and wRVU’s equal to the 75th percentile of her peers when compared to industry benchmarks. These same industry benchmarks indicate that compensation at this level of productivity should be about $50 per year. Therefore, the real economic benefit of owning the practice is $100 less the $50 that a physician could expect otherwise in the open market for providing comparable services.

In conclusion, the income approach is an effective method for valuing a physician practice; however it is crucial that the perceived economic benefit to a prospective purchaser is based upon an accurate accounting of the practice’s income. The adjustment to income that commonly has the greatest effect on a practice’s value is in regard to the physician owners’ compensation.

If you have any specific questions regarding this article or if you would like to suggest a topic for upcoming articles, feel free to call or email Jeff Moffatt at 317.275.7405 or jmoffatt@blueandco.com.