How much is your practice worth? -- Part II. (Nuts and Bolts of Business).

Once the appropriate information is obtained for a practice valuation, how does the valuator determine the price for a buy-in?

The two most common valuation methods include the income approach using discounted cash flow analysis and the market approach that values the practice by comparing it to other practices with similar operations.

Most valuators will use more than one method to determine the practice value and compare the results for consistency.

Of the two, the market approach is the easier to understand since it is the approach most commonly used to value real estate transactions. The income approach is less familiar to many physicians without formal business training.

Income approach

There are three basic elements to the income approach to valuation.

1. Cash. To place a value on something, we must determine the cash flows involved.

2. Timing. We must determine the value of the cash flows in today's dollars.

3. Risk of those cash flows. We must answer the question as to how likely we believe the projected cash flows are to occur.

Since cash is what pays the bills, the first step in the valuation process is to convert all assets to cash flows. For the vast majority of medical practices, the greatest asset is the accounts receivable. The accounts receivable must be converted to cash flows. Knowledge of how cash comes into the practice is a crucial component of this analysis.

The second component is risk. Imagine that you are considering making an investment with an expected rate of return of 10 percent. The risk-return trade-off tells us that we should not make an investment unless we expect additional compensation for the risk we are taking.

In other words, from a financial standpoint, we should not make the investment if our required rate of return is less than the expected rate of return.

How do we determine our required rate of return? The most common method in finance of determining the required rate of return is by determining the weighted average cost of capital (WACC). This formula simply adds the weighted cost of debt to the weighted cost of equity to determine the required rate of return.

Assume that the cost of debt is 5 percent and that debt makes up 20 percent of your capital structure, while the cost of equity is 15 percent and that equity constitutes 80 percent of your capital structure.

The weighted average cost of capital (WACC) is then: WACC= (5%)(20%) + (15%)(80%) = 1% + 12% = 13%

Therefore, your required rate of return (discount rate, hurdle rate) is 13 percent. From a purely financial standpoint, you should not make the investment since the required rate of return exceeds the expected rate of return.

Elements of the WACC

The next question is how do we determine the elements of the WACC?

The percent of debt and equity in the capital structure is obtained from the practice's balance sheet. The calculation for the cost of debt is a simple one. It is determined by how much a company pays in interest on its debt multiplied by one minus the tax rate.

For example, if your debt rate is 5 percent and your corporate tax rate is 22 percent, then your cost of debt is:

Cost of Debt = 5% x (1 - 22%) = 4%

For not-for-profit corporations, which do not pay income tax, it is equal to the debt rate. The cost of equity is more difficult to determine. The most commonly accepted method in finance is the capital asset pricing model (CAPM). See Figure 1.

There are three major elements to the CAPM. The first is the risk free rate. This is the rate of return you can expect on risk-free investments. The standard risk-free investment by which this is measured is the 90-day U.S. Treasury Bill. The current rate of return on T-Bills may be obtained from publications such as The Wall Street Journal. Let's assume for our example that it is 2 percent.

The second element of the CAPM is the expected rate of return on a market investment. The 45-year historical average has been in the range of 10-12 percent. For this example, we will set the expected rate of return at 12 percent.

The final component is beta, which represents the measure of a company's stock risk relative to the overall market. For publicly traded companies, an estimate of the beta may be obtained from publications such as Value Line.

Taking a company's stock returns and plotting them against the returns of the S&P 500 determines beta, Linear regression analysis is then used to determine the slope of the "best fit" line through the plotted points. Beta is the slope of the "best fit" line. Therefore, beta is measured relative to a risk level of one.

Those companies with the same risk as the overall market will have a beta of one. Likewise, those with a beta of greater than one would have more risk and those with less than one, less risk.

For example, a high tech company may have a beta greater than one, reflecting the volatility in the industry. On the other hand, a utility company may have a beta less than one, reflecting stability and near constant returns for these industries.

Figure 2 shows the impact of changing beta on the cost of equity.

As you can see, changing the value for beta will have an effect on the determination of the cost of equity. The higher the beta is, the greater the cost of equity. This makes sense, if we remember the risk-return tradeoff. The greater the risk, as evidenced by the higher beta, the greater the required rate of return.

Timing

The final element in income valuation is timing.

In order to value our investment, we must know what the expected cash flows from that investment are worth in today's dollars. This is accomplished by determining the net present value (NPV) of the cash flows. Calculating the NPV requires determining the cash flows and the required rate of return.

Let's look at an example to understand the relationship between cash flows, the required rate of return and the net present value. Assume that you have projected cash flows of $500,000 per year for the next five years. What are those cash flows worth in today's dollars? In other words, what is the NPV of those cash flows?

In order to answer that question, we first must determine the risk of those cash flows, as measured by the required rate of return calculated by our WACC.

Figure 3 shows what happens to the NPV of the cash flows as we increase the WACC (risk).

As you can see, the higher the WACC, the greater the risk in achieving those projected cash flows and the less the value we place on them in today's dollars. To calculate the actual NPV requires a NPV table, financial calculator or financial spreadsheet software, such as Microsoft Excel[R], in which you determine the cash flows, plug in the required rate of return and calculate the NPV.

How then does the valuator use the income approach to valuation?

First, the consultant converts all assets to cash flows. Those cash flows are then projected for al least five years. Next, the consultant should determine a range of net present values for the cash flows by adjusting the risk (remember our discussion of beta).

Finally, the value of the practice is divided by the number of partners, including the one being offered partnership, to determine the buy-in price.

Let's look at an example. Suppose that by varying the risk, the consultant produces a range of net present values of between $700,000 and $1,000,000. There are 10 partners, including the one being offered the buy-in. The value of a partnership is between $70,000 and $100,000. This value would then be compared to the value obtained from an alternative methodology. You would then have to negotiate between $70,000 and $100,000 to determine the actual price to be paid.

Goodwill

One of the greatest areas of contention in determining the value of a practice involves goodwill. Goodwill is the value that is placed on non-tangible assets. These assets include such things as the location of the practice, the reputation of the partners, any competition in the area, and the like.

The question remains, should someone pay you for these non-tangibles, and if so, how much?

There is no easy answer. The consultant performing the valuation should determine how goodwill has been handled in transactions in the geographic region in which you are working.

On average, goodwill has added anywhere between 5 percent and 15 percent to the value of most practices. It is important to note, however, that the valuation of goodwill has fallen out of favor recently, since the widespread demise of many physician practice management companies which overvalued goodwill in their practice purchases.

Finally, remember that when you negotiate the buy-in price, you are negotiating with people who will be your partners and most likely friends for years to come. You should be looking for fairness. It should not become contentious.

You must get expert legal and financial assistance to help you with this process. The amount of money it will cost you will be well worth the investment.

FIGURE 1

FORMULA FOR THE CAPM.

Ke = Krf + [beta] (Km - Krf)
Ke = cost of equity

Krf = risk free rate = 90-day Treasury Bill rate

Km = expected market rate of return

[beta] = measure of risk compared to the overall market
FIGURE 2

THE IMPACT OF BETA ON THE COST OF EQUITY

Assume: Krf = 2%, Km = 12%

If Beta = 0.5, Ke = 2% + 0.5 (12%-2%) = 7%

If Beta = 1.0, Ke = 2% + 1.0 (12%-2%) = 12%

If Beta = 1.5, Ke = 2% + 1.5 (12% - 2%) = 17%
FIGURE 3

THE IMPACT OF THE WEIGHTED AVERAGE COST OF CAPITAL (WACC) ON NET PRESENT
VALUE (NPV) OF CASH FLOWS

If WACC = 10%, then NPV = $2.1 million

If WACC = 15%, then NPV = $1.9 million

If WACC = 20%, then NPV = $1.8 million

David P. Tarantino, MD, MBA, is the executive medical director of Shock Trauma Associates, P.A., a 50+ physician, multispecialty practice associated with the University of Maryland School of Medicine. In addition, he is the chief executive officer of The MD Consulting Group, LLC, a health care management consulting firm in Baltimore, Md. Tarantino can be reached by phone at 410/328-3198 or by e-mail at [e-mail].