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Rules of Thumb – Their Pitfalls

It is not uncommon for me to be asked to “ballpark” a value for someone, often with the expectation that limited information is all that is necessary to derive a value. Each and every time this happens, I have a visceral response. My reaction is caused by the knowledge, that any figure I were to provide could miss by a mile. The view of value between most business owners and valuation specialists is vast. Typically, the owner, fails to understand that it is the expected bottom line cash flow that drives value, whereas the valuation specialist, focuses on the drivers of future cash flow. Owners tend to look at the top line gross revenue; valuation analysts look at “bottom line” income and cash flow. Therein lies the problem.

To illustrate this point, let’s look at physician practices. The value of physician practices that seem similar, can vary greatly. For example, reimbursement rates can vary so that the same volume of patients would render different top-line gross revenue figures between practices. In addition, the sheer number of practitioners working in a practice, can make the comparability of practices difficult. A fifty person practice might have more value simply because of the number of physicians employed in comparison to a ten person practice, especially if different types of medicine are practiced within the larger group.

In addition to the potential for differences in top-line revenue, there are a myriad of factors that can affect the bottom line of a practice. Please give consideration to the following:

1. Staffing usage and costs – no two practices are the same in terms of the number of employees, their efficiency and the related benefits associated with their employment. Employers often pay varying portions of health insurance and other benefits. In addition, some will pay toward employees’ retirement plans, while others will not.

2. Rent – can vary based not only on the number of square feet rented, but also the cost per square foot. In addition, overcapacity could negatively impact the profitability of the practice. Other peripheral costs, such as utilities and real estate taxes can affect the overall rent depending on the terms of the lease. Lastly, and maybe most importantly, is whether the rent paid represents fair market value. If rent is paid to a related party, it is not uncommon for the rent paid to be used as a way to reduce the profitability of the practice and thereby save on taxes. Without analyzing the rents, the practice looks less profitable.

3. Perquisites (owners benefits deducted by the company) – the types and amounts of perquisites paid will vary. In some instances, perquisites may be limited to small amounts, such as automobile expense reimbursements, while in others any number of items, such as personal credit card expenses, may be paid by the practice thereby lowering the profitability of the practice.

4. Fixed asset reinvestment – the amount of money reinvested back into a practice, whether on the physical structure or on equipment, will potentially affect the profitability and the cash flow of the practice. Two otherwise identical practices but with different depreciation amounts will have very different income amounts. In addition, a practice that did not reinvest may likely be less desirable than one that did. This does not begin to address whether the company is using accelerated depreciation and bonus depreciation to lower income.

The common theme of these comments is that they all impact the profitability of a practice and the cash flow an owner can receive. As a result, if one were to apply a rule of thumb to either gross or net revenue, the likelihood of arriving at a reasonable value is very slim.

Another important consideration is whether the practice’s historical results will have any bearing on future anticipated results. Qualitative considerations such as new competition, aging physicians and a slew of other items need to be given proper consideration.

Hopefully, these comments explain why rules of thumb, can render an improper result. In addition, one can begin to appreciate why when someone references “the value of a friend’s practice” as a benchmark for their own, the flaws can readily be seen.

As a result of the above, if someone needs an estimate of value, but does not want all the bells and whistles of a full appraisal, I encourage the preparation of a calculation of value. This allows the appraiser to perform agreed-upon calculations based on different approaches and methods, while foregoing the cost of a full valuation.

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