It's (somewhat) about the money (Part 2)

Key Points

MEDICAL PRACTICE VALUATION

In recent years, medical practice valuations have been low and uncertain, and we expect this trend to continue. Many doctors feel that rather than buying an existing practice, they can earn equivalent income by establishing a competing practice. Therefore, a prospective buyer may only be willing to pay a "convenience and acceleration" fee for purchasing a going concern with patient charts, personnel, an established location, and protocols. The benefits associated with an existing medical practice typically are nowhere near 1 times gross revenues or net profits.

By contrast, Wall Street's price/earnings ratio in the Standard & Poor's 500 Index is 15 to 1, meaning that a company earning $1 per share would sell for $15 per share on average. If a corporation could buy the practice described above and replace the doctor with one who would work for $300,000 a year, and have strategies in place to enhance profitability, then the value of that practice on Wall Street could be $15 million.

Stock prices are often based upon anticipated earnings-and executive bonuses are often based on stock prices. Thus, if a company such as HCA can tell Wall Street that it anticipates increased earnings because of physician practice acquisitions costing less than one times earnings, and that the resulting earnings increases may be on a 10 times earnings model, then executives at the company may receive bonuses as stock prices increase, based upon projected earnings and not the actual success of the model.

Another example would be a 20-physician group where each physician makes $300,000 per year ($6 million worth of income) being acquired for $6 million with each physician then accepting a salary reduction to $250,000 in exchange for an upfront payment and a share in any future income growth.

Expected increases in profits from ancillary and in-patient hospital functions might be $1 million per year. If the profit from the $50,000 per doctor payroll reduction is $1 million, and the expected increases in profits from ancillaries are $1 million per year, then projected future profits will be $2 million. If HCA stock is trading at 10 times earnings, the result is a $20 million value from a $6 million investment. This makes it more than worthwhile for HCA or another corporation to come calling with enough cash to make the transaction a reality.

This is how some practice management companies had huge increases in their stock prices, followed by abysmal losses and eventual financial failure during the 1990s. They failed once Wall Street realized that they could not enhance income, and that the medical groups they purchased actually performed much worse due to lower pay and poor management. Many doctors had to fight their way out of these contracts by litigation or negotiation. It was an unpleasant experience for many participating doctors.