Establishing the Value of a Medical Practice Using the Excess Earnings Method

The financial value of a medical practice is composed of two parts: (1) “goodwill,” which is an intangible value associated with the name and reputation of the medical practice, and (2) the current value of the equipment (hard assets) of the practice, not including real estate. If the practice owns its own medical office building, this is generally handled in a separate sales transaction based on an independent current value appraisal.

There are several methods for establishing the value of the goodwill, and each one has its drawbacks. The “Comparable Sales” and “Income” approaches are complex, often based on data spanning several years and geographic areas, and sometimes use a discount rate to value future cash flows that may not be accurate in a time of fluctuating interest rates.

The “Excess Earnings” method is a simple and easily understood way of establishing the value of goodwill specific to the practice, focused on a point in time (generally the end of the most recent fiscal year), and is less subjective than other methods. It is based on the concept that the value of goodwill is equal to the difference in total compensation paid to current owner(s) and the compensation of a new physician(s) starting practice out of residency.

The total compensation for an existing (selling) physician is set as the value of salary + bonus + distributions + the practice’s share of his FICA (Social Security + Medicare) tax + personal expenses (practice-provided benefits in excess of basic health insurance and medical education compensation) for one fiscal year. This information can be found in Federal Income Tax filings (Schedule C for an individual owner) and the practice’s internally produced pro-forma.

All benefits in excess of what a new physician would receive, which are paid for by the practice, should be added into the value of the existing physician’s compensation. Examples of such benefits are an automobile allowance, personal disability insurance, and “key man” insurance.

The compensation of a new physician of the same specialty can be readily accessed through the MGMA Provider Compensation and Production Report. It contains a section titled “First Year Post-Residency” with mean and median compensation figures. This document is produced annually, with published salary levels one year in arrears. To compensate for this one-year lag in current compensation, an inflation factor (also available from MGMA) from the prior year can be used to estimate the current market- based compensation.

For example, for Family Practice (without OB), the median compensation (MGMA 2017 report using 2016 data) was $185,000. The percentage change in compensation from the prior (2015) year was 1.51%. Updating the 2016 compensation using the 1.51% prior year inflation figure yields a new physician average compensation for 2017 of $187,800 (rounded). To this amount should be added the practice’s share of the FICA tax.

As an example, Dr. Smith, a Family Practitioner (no OB) was compensated in 2017 as follows:

The above example sets the value of goodwill at only 1 times the excess earnings. Depending on the specialty, it is common to set the value at a multiple of year one, based on the premise that most medical practices starting from day one will not be as profitable as a mature practice until at least 3 years of operation.

When projecting the value of Goodwill, it is important to examine the expenditures of the medical practice to eliminate any one-time expenses that will not be repeated within the future 3 years post-acquisition, and add in any known major future expenses necessary to continue the practice producing at the same level as the base year.

The value of the hard assets of the practice can be estimated using the current depreciation schedule, which should list all practice assets, the date they went into service, and the depreciable life.

For most capital equipment (non-fungible items with an initial acquisition value over $1,000), a general value can be found by comparing similar used items from on-line equipment vendors. For IT equipment, it is best to use the services of a IT consultant to evaluate the existing equipment and its useable life. For fungible inventory items (office supplies, medications) it is best to estimate a “global” value rather than to try and itemize each one.

The total value of the practice will be the sum of the goodwill and the hard assets.

It is important to involve the practice accountant at the beginning of the process. This person should have an in-depth insight into the items in the depreciation schedule and can advise on the tax effect on depreciable assets for the purchaser. For example, it is important to understand that goodwill must be amortized over 15 years, but most equipment can be depreciated over one year, using the accelerated depreciation rules.