Valuing your medical practice: Key approaches and considerations for ownership transitions

Anthony Venette: ©Dejoy, Knauf and Blood LLP

One thing I’ve learned over my career is that valuing a medical practice correctly is both art and science. As a practice owner, understanding the true value of your business is crucial, especially when planning for an ownership transition. Whether you're considering selling your practice, bringing in a partner, or preparing for retirement, having a clear and accurate valuation is essential for making informed decisions about your practice’s future. Otherwise, you may be forced to accept an inferior offer that you’ll regret for years to come.

First I will highlight key valuation approaches relevant to medical practices like yours. Then we’ll review important considerations, followed by a real-world example to illustrate these concepts. Although the principles apply to all medical practices, the example focuses on a pediatric practice, with future discussions diving deeper into specific specialties.

Understanding the Valuation Approaches

When valuing your medical practice, there are three primary approaches:
1. Income Approach.
2. Market Approach.
3. Asset (Cost) Approach.

For most private practices, the Income and Market approaches are more applicable, but it’s important to be familiar with the Asset Approach as well.

Income Approach estimates the value of a medical practice based on its ability to generate future income. Two common valuation methods under the Income Approach are:

• Capitalization of Earnings Method which uses the practice’s historical earnings -- adjusting for growth and risk factors -- to determine the value. This method applies a capitalization rate to the practice’s earnings, which reflects both risk and expected growth. For private medical practices, higher capitalization rates are often used to reflect uncertainties and market conditions.
• Discounted Cash Flow (DCF) Method involves projecting future cash flows and discounting them back to the present value. This method is particularly useful for practices that have stable, predictable cash flows. DCF is often used when a practice is expected to experience changes, such as new revenue streams or growth.

Market Approach values a practice by comparing it to similar practices that have recently been sold. There are two primary methods of doing so:

• Comparable Transactions Method involves reviewing sales of similar practices in terms of size, specialty, location, and revenue. This method also provides insight into the market demand and establishes a fair market value based on real-world transactions.
• Guideline Public Company Method. Although less commonly used for private practices, this method compares a practice to publicly traded companies in the healthcare industry. Adjustments are made for size and profitability differences to determine value. For private medical practices, this method is typically less relevant.

Asset (Cost) Approach values a practice based on the value of its tangible assets—such as medical equipment, office space, and other physical assets—minus its liabilities. While this approach is useful for liquidation scenarios, or when valuing highly asset-intensive businesses, it is not generally applicable to private medical practices. This is because the true value of a medical practice is driven by its ability to generate income, and by the goodwill associated with its patient base and relationships. Value is NOT driven, by its physical assets. As a result, the Income and Market Approaches are more meaningful for determining the value of your private practice.

Factors considered in valuations

In addition to the financial metrics used in the Income and Market Approaches, several subjective factors can significantly impact the valuation of your medical practice:

• Geography. The location of the practice plays a critical role in its valuation. Practices in urban areas with high demand for medical services may receive a higher valuation than practices in rural or other less populated areas.
• Patient base. A diverse and stable patient base is a key driver of a practice’s value. Practices that have long-term relationships with patients, a mix of age groups, and strong referral networks tend to command higher valuations than more homogenous practices.
• Age and condition of technology. The technology and medical equipment your practice uses can greatly impact its value. Practices that have invested in modern medical technology, EHR systems, and updated office equipment are more attractive to potential buyers than those with dated technology and equipment.
• Remaining tenure of physicians. The tenure and future availability of key physicians will significantly impact a practice’s value. Buyers often look for practices in which the physicians intend to remain with the practice post-sale, as continuity of care is crucial for maintaining patient relationships.
• Reputation and brand. A practice with a strong reputation for patient care and a recognizable brand in the community can command a premium over those with less established names.

These subjective factors, when combined with financial analysis, provide a comprehensive view of a practice’s true value.

Valuation example: A pediatric practice

Let’s consider the example of ABC Pediatrics to illustrate how the Income and Market Approaches work in practice, along with considerations of free cash flow.

ABC Pediatrics has been operating for over 20 years and serves a stable patient base with consistent revenue streams. The practice generated approximately $1.6 million in revenue in 2023, with operating expenses of $1.2 million, resulting in operating income of $400,000. After factoring in additional tax expenses, capital expenditures, and required working capital, the practice’s free cash flow amounts to $250,000.

Using the Income Approach, we apply a higher capitalization rate of 25% due to the risks associated with the practice’s future growth and potential market shifts. The Income Approach gives us a valuation of $1 million based on its free cash flow, reflecting a more conservative assessment of the practice’s earnings capacity and future performance.

Under the Market Approach, however, we compare ABC Pediatrics to similar pediatric practices recently sold. Let’s say recent transactions of similar pediatrics practices show average revenue multiples of 0.65x and average EBITDA multiples of approximately 2x. Applying these metrics to ABC Pediatrics, the practice’s value could range between $1.04 million (based on revenue) and $760,000 (based on EBITDA). Considering these comparisons and real-world conditions, a reasonable valuation for ABC Pediatrics would likely fall around $1 million.

Price vs. value: The distinction in practice valuation

It’s important to distinguish between fair market value and the actual price paid in a transaction. Fair market value is defined as the price at which a practice would sell in a hypothetical transaction between a willing buyer and a willing seller. This assumes both parties have reasonable knowledge of the relevant facts and neither is under compulsion to act. This is the value of your practice in a theoretical vacuum.

In reality however, price refers to the actual consideration paid in a transaction. The price can be influenced by many factors beyond the fair market value, such as the urgency of the sale, negotiation strength, or specific buyer motivations. While an accurate valuation provides a reliable estimate of a practice’s worth, it cannot guarantee that a buyer will transact at that price. The final price is always subject to the specifics of the deal and market conditions at the time.

Valuing your medical practice is a multifaceted process that requires careful consideration of financial performance, market conditions, and subjective factors. By focusing on the Income and Market Approaches, you can gain a more accurate understanding of your practice’s worth and set the stage for a successful ownership transition. While these principles apply broadly across all medical practices, the nuances of specialty practices—such as pediatrics—add another layer of complexity.

Conclusion

Ownership transition planning can be challenging, and getting the first conversation right is crucial. For more insights about the financial and legal intricacies of practice transitions, consider reviewing foundational concepts I’ve covered above. In the meantime, use these valuation principles as a roadmap for understanding the value of your practice and for navigating the transition process effectively.

Anthony Venette, CPA/ABV is a Senior Manager, Business Valuation & Advisory, with Dejoy, Knauf and Blood LLP (DKB), a BDO Alliance firm based in Rochester, New York. He provides business valuation and advisory services to corporate and individual clients of DKB.