Health-care practices are valued for a variety reasons, among them -

* sale or purchase of practice,

* estate planning,

* admission or withdrawal of a partner/shareholder,

* preparation of personal financial statements, and

* combination or affiliation with other practices.

Of the reasons identified above, the last will have increased significance if national health-care reform (NHCR) ever becomes a reality. If President Clinton has his way, legislation will require cost controls by, and universal access to, health-care providers. This leads to the reasonable conclusion that, regardless of their specialty, many - if not most - health-care providers, from large group practices down to the sole practitioner, will seek to combine their practices or, at the least, affiliate themselves through health-care networks. We saw that even the mere discussion of NHCR in the hallways of Congress sent many providers scrambling to find the right affiliation.

For ease of presentation, this discussion focuses on valuation of a medical practice, although the techniques identified would be applied in substantially the same fashion to the practice of any health-care provider.

The CPA's Role

In some cases, the CPA may be engaged to apply required valuation techniques; in other cases, the CPA may be engaged to either report on financial statements that contain values or advise clients with respect to values that were determined by others. And CPAs employed by health- care providers will often find themselves in the position of preparing or evaluating valuations of practices. Whatever the situation, CPAs must understand how the values are determined.

The Valuation Objective

The objective in valuing a health-care practice is to determine the practice's fair market value (FMV). In Rev. Rul. 59-60, one of the most widely relied upon revenue rulings for determining FMV of a closely-held company, the IRS defines FMV as follows:

The amount at which the property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy, and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts.

But the IRS provides very little practical guidance in determining FMV. Practically speaking, FMV is not a precise amount, but the average of a reasonable range of amounts determined by a variety of acceptable approaches. A great deal of judgment is involved in applying the underlying valuation techniques, because so many different factors enter into the determination.

In the paragraphs following, the emphasis is on how the determination of FMV was made for the midtown family medical practice of Dr. Jones, as of June 30, 1993. The FMV of that practice was based on a combination of the following three valuation methods:

* Market comparable approach (MCA),

* Composite approach (CA), and

* Discounted cash flow approach (DCFA).

TABULAR DATA FOR EXHIBIT II OMITTED

Market Comparable

MCA compares Dr. Jones' practice to similar practices that have been sold recently. MCA is a logical starting point because it involves use of recent information applicable to consummated trans actions between unrelated parties dealing at arm's length. Exhibit I lists the types of information that would be used in applying MCA. Such information can be obtained from one or more practice brokers.

A critical factor to bear in mind when applying MCA is no matter how similar the subject practice is to comparable practices, there will be characteristics that differ, and those differences must be considered.

Exhibit II illustrates application of MCA. The illustration compares and contrasts various characteristics of Dr. Jones' practice to those of four recently-sold similar practices.

Based on the information in Exhibit II, "average goodwill as a percentage of gross fees" applicable to Dr. Jones' practice is 54%, which is derived as the sum of the "goodwill as a percentage of gross fees" for comparable sales A, B, C, and D and dividing by four, or in this case, 58% + 50% + 63% +45%, divided by four.

Therefore, a reasonable FMV of Dr. Jones' practice under MCA would be $383,000, derived as follows:

Grossfees$450,000

xAveragegoodwill

asapercentageof

grossfees54%

243,000

+FMVofnettangible

assets140,000

FMVunderMCA$383,000

Composite Approach

CA is based on two components, a gross fees component and a pretax income component. CA compares common elements found in the subject practice to an ideal practice by using a practice rating sheet (PRS) (see Exhibit III). The PRS was self-developed, from a survey, to compare subject practices to an "ideal practice." The rating sheet is based on a 100 percentage point rating system weighted for 15 critical practice elements, also developed from the survey.

The comparison of a subject practice to an ideal practice is a very subjective process and requires the evaluation and analysis of the 15 critical practice elements as illustrated by the PRS. Once a subject practice has been percentage-rated against the ideal practice, the percentage rating is multiplied by .60 and 1.60, standard health-care practice market factors for gross fees and pretax income, respectively. The resulting percentages are applied to the subject practice's gross fees and pretax income, and the resulting values are added to the FMV of the net tangible assets to obtain a reasonable FMV of the practice. Based upon the average of the two components, a reasonable FMV under the CA for Dr. Jones' practice is $335,050, derived as shown in Exhibit IV.

Discounted Cash Flaw Approach

DCFA is a valuation technique that makes a pro forma analysis of the subject practice to estimate future available cash flow. Available cash flow is the amount that could be paid out to the practitioner, after an imputation is made for normal compensation, without impairment of the practice's ongoing operations. The components of DCFA are the present value of the cash flow from the practice plus the present value of the practice's residual. Stated more simply, the value of the practice's projected future earnings is discounted to the present, based on the last 3-5 years' historical results. The projection period (n) used is typically a 10-year period. It should be kept in mind, however, that the life of the practice does not terminate at the end of the projected period but, can continue in perpetuity as new partners/shareholders or purchasers carry on the life of the practice. Therefore, a present value for the practice's residual value needs to be determined.

EXHIBITIII

PRACTICERATINGSHEET

IdealDr.Jones'

PracticePractice

Grossfees108

Profitability105

Location88

Growthpotential77

Collections33

Newpatients55

Lease54

Equipment66

Staff77

Recalls51

Competition86

Patientbase66

Transferability74

Practicecomposition

(Treatmenttypes)77

Patienttypes66

10083

To calculate the residual value of the practice at the end of the projection period, the annuity-in-perpetuity method is used. The annuity-in-perpetuity method is defined by the following equation:

1 / k-g = cash flow multiple

where, k = discount rate

g = long-term cash flow growth rate

The discount rate (cost of capital), in financial theory, is defined as the minimum rate of return that the practice must earn to leave the FMV of the practice unchanged. The discount rate is derived by adding the risk-free rate (the yield in a long-term Treasury bond at the valuation date) and a risk premium.

EXHIBITIV

THECOMPOSITEAPPROACH

GrossFeesComponent

Grossfees$450,000

Grosscompositefactor(.60x.83)x.498

Valueofintangibles224,100

FMVofnettangibleassets140,000

FMVofgrossfeescomponent$364,100

PretaxIncomeNetComposite

Component

Pretaxincome$125,000

Netcompositefactor(1.6x.83)x1.328

Valueofintangibles166,000

FMVofnettangibleassets140,000

FMVofpretaxincome$306,000

SumofTwoComponents

Grossfeescomponent$364,100

Pretaxincomecomponent306,000

670,100

dividedby2

FMVunderCA$335,050

TABULAR DATA FOR EXHIBIT V OMITTED

To determine risk premium, consult a source such as Ibbotson and Sinquefield's Stocks, Bonds, Bills, and Inflation, which shows a six percent premium above the risk-free rate.

In applying the DCFA to Dr. Jones' practice, the following is assumed and illustrated in Exhibit V:

* Pretax income to practice (comparable sales data) before income to the practitioner is the same as cash flow except normal compensation must be imputed for services provided by the practitioner. For the period ending June 30, 1994, those services provided by an outside practitioner were assumed to cost the practice $100,000 and to increase at the rate of 2.7% per annum (consistent with inflation).

* Long-term cash flow growth rate, g = 2.7%, consistent with inflation, and is also applied to normal compensation for services.

* The discount rate was the long-term Treasury bond rate at June 30, 1993, (6.71%) plus a risk premium of six percent or 12.71%.

A reasonable FMV for Dr. Jones' practice under DCFA is $308,946, derived as illustrated in Exhibit V.

Based on the three approaches (MCA, CA, and DCFA), a reasonable FMV of Dr. Jones' practice as of June 30, 1993, was $340,000, derived as follows:

MarketComparableApproach$383,000

CompositeApproachFMV335,050

DiscountedCashFlow

Approach308,946

1,026,996

dividedby3

$342,332

Roundedto$340,000

Conclusion

Because valuations of practices usually involve a substantial amount of goodwill, pragmatically, the methods employed are not as structured as valuations for tangible or real property. In the valuation of a health- care practice, there is no universal acceptance of any specific approach. Furthermore, there is no consensus among professionals that the valuation of a practice should he conducted using a particular approach or number of approaches. The valuation of a practice should be based upon the practice's ability to generate future earnings. Therefore, emphasis should be placed on the development of one or more measures of the practice's future earnings potential and an appropriate rate of return that a prospective purchaser might expect, given the various risks involved in operating the practice. In the case of Dr. Jones' practice, an average of three widely accepted valuation approaches was appropriate.

RELATED ARTICLE: EXHIBIT I

MARKET COMPARABLE APPROACH PRACTICE INFORMATION

* History and nature of the practice

* Geographical location

* Gross income, both current and for several preceding years

* Net income, and the likelihood of changes in future earnings

* Characteristics of the patient base

* Competition

* The physical facility, including age and condition of equipment

* The lease for the facility and/or the purchase price of the facility

* The fee structure in the practice

* Staffing

* Transferability of the practice

* The practices net tangible asset value

* Payment terms of the sale

RELATED ARTICLE: NEW SOFTWARE CALCULATES VALUE OF MEDICAL PRACTICES

While the health-care industry faces reform, many practitioners are consolidating and integrating vertically. Many physicians are leaving their practices to join health-care corporations, hospitals, or large physician-owned groups. As this migration continues, the need to obtain values of these practices grows. To assist in the valuation, Wiley- ValuSource has released a PC-based software package - Appraisal M.D.

Designed for a sole practitioner, partnership, or professional corporation, the software provides medical practice analysis and documentation that can also be used for litigation support. Based on the format established by the American Medical Association (AMA), Appraisal M.D. can generate statements for -

* performance reviews,

* industry reviews,

* forecasts and budgeting, and

* practice valuation.

Appraisal M.D. contains key reference libraries which facilitate the management and collection of data to support statements. Structured as databases that can be accessed at any time, the libraries are -

* Socioeconomic Characteristics of Medical Practice (1990-1994), American Medical Association;

* Goodwill Registry (1990-1994), The Health Care Group, Inc.;

* Cost of Capital Quarterly (1994 Health Care SIC Code 8000). Ibbotson Associates; and

* MergerStat Review (1993 Health Care), Merrill Lynch.

To order Appraisal M.D., call John Wiley & Sons, Inc., at (800) 825- 8763.

Mark I. Massad, CPA, is a partner of Kelly Massad LLP. Mr. Massad has assisted with the valuation, acquisition, and sale of a variety of professional health-care practices.