Determining the Required Rate of Investment Return

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Financial Fundamentals of Medical Practice Sales

Dr. David Edward Marcinko; MBA, CMP™

[Editor-in-Chief]

A physician investor’s required rate of return, for the sale of a medical practice, takes into account that monies received sooner have a greater value than those received later. And, the greater the risk in receiving future cash flows the lower their current value. Moreover, one must always keep in mind returns that can be earned on alternative investments.  A required rate of return takes all these factors into account.

The Process

The process of selecting an appropriate required rate of return begins with an assumption that all investors will require, at a minimum, the riskless rate of return offered by government securities. Government securities with a maturity similar to that of the duration of the investment in a private [practice] company are selected, and normally; and a duration of ten to twenty years is used. Because of the minimal default risk associated with government securities, the rate is referred to as the risk free rate. THINK: Freddie Mac and Fannie Mae.

Physician Investors

Investors typically require returns greater than the risk free rate. The additional return (in excess of the risk free rate) is called the risk premium.  Risk premiums are generally calculated through an analysis of historically realized rates of return segmented by varying levels of risk, and medical practice specialty, etc. This analysis illustrates that higher historical rates of return occur in situations of higher risk. For example, securities issued by the U.S. government have lower rates of return than securities issued by large corporations. Returns on the equity of large corporations are greater than those of debt securities issued by the same firms. Thus, historical rates of return are generally used as a proxy for future required rates of return; despite the market implosion of 2008-10.

Healthcare Business Valuation

When valuing a medical practice, clinic or healthcare business entity, one must compare the risk of the expected cash flows of the entity being valued to the risk of the cash flows of like [private] publicly traded securities and to determine an appropriate required rate of return based on that assessment.

Cash Flows

It is generally assumed that the expected cash flows from an investment in a closely held healthcare business are at least as risky as those of large publicly traded firms. The combination of the large firm equity risk premium and the risk-less rate of return provide an indication of the required rate of return for the buyer or seller. Beyond that, additional risk premiums related to entity size, proportion of debt and health industry conditions exist; and many other possible company specific risk factors may be appropriate.

Assessment

When valuing a small business like a medical practice, we appraisers generally employ required rates of return 10 percent to 30 percent beyond the current long-term risk free rate for the risky and fragmented healthcare industrial complex.

In summary, the required rate of return used to value a closely held medical business represents the return a physician investor demands to invest funds now with the expectation of the uncertain cash flows associated with ownership of a private company.

Conclusion

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What is the Cost of eHRs?

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A Retrospective Look-Back

By Richard J. Mata; MD CIS CMP™

Studies by the Organization for Economic Cooperation and Development (OECD) show that healthcare spending in the U.S. accounts for 16-17% of GDP, which is more than six-seven percentage points higher than the average of 8.9% in other OECD countries.  This translates into per capita health spending of $5,635 in the U.S. compared with median costs of $2,280 in other OECD countries.[1]  Suggestions as to the economic drivers of U.S. health spending include excessive service use, administrative complexity, population aging, threats of malpractice litigation, defensive medicine practices, and the lack of patient waiting lists.  In further comparisons with the OECD countries, it appears the U.S. overpays for physician visits, hospital stays, and pharmaceuticals.

In the Year 2004

A 2004 OECD paper suggested that one way of improving performance would be to move towards EHR:

Health systems should invest in automated health-data systems, including electronic medical records and systems to automate medication orders in hospitals. Better systems for recording and tracking data on patients, health and health care are needed to make major improvements in the quality of care.[2]

In the U.S., possible savings from the adoption of EHR have been projected to reach $142 billion in physician office visits, and $371 billion in hospital costs over a 15-year period.  These projections have not been validated by the experience in other OECD countries where the adoption movement is ahead of U.S. efforts by anything from four to thirteen years.

Nevertheless, the U.S. began its quest to move towards EHR in 2004 as medical software companies began actively marketing their systems, although funding for this endeavor did not come through until 2006.  In spite of this effort, the U.S. has the lowest percentage of physician providers using any EHR compared to Germany, Canada, United Kingdom, and Australia.  The U. S. physicians’ low adoption rate involves fear of the loss of productivity, lack of financial incentives, and high startup costs of as high as $40,000 per physician EHR adoption.

When spending on IT implementation in the healthcare system is compared on an international level, the U.S. lags dramatically behind the major OECD countries.  The U.S. spends $0.43 per capita compared to a high of $193 in the U.K.  This difference is even more dramatic when compared with the German experience, where IT adoption in the healthcare system is almost universal.  In thirteen years, Germany has spent $1.88 billion.  Their annual per capita cost has been $1.63.  The U.S. has reached only 25% of that expenditure so far.

Barriers to Adoption

The greatest barrier to adoption of EHR in most OECD countries has been the need to simplify the health insurance contracts payment structures with standard nomenclatures that can be adapted to EHR.  The major OECD countries also report that there must be a national adoption of IT standards in the healthcare system as well as a national effort to focus on privacy and confidentiality standards.  This assures better coordination of implementation and provides better strategies for adoptions through public incentives and grants.

 

Domestic 5 Year Costs

In the U.S., the five-year costs for a national IT healthcare network have been estimated to be as high as $103 billion in capital and $53 billion in interoperability.  Hospital costs for functionality were estimated to be $51 billion, skilled nursing facilities would bear $31 billion of costs, and physician offices would bear $18 billion of the costs. (Anderson, 2006)  EHR systems that have been implemented have been used mainly for administrative rather than clinical purposes.

In the Year 2005

A 2005 study by Richard Hillestad and colleagues at RAND[3] estimates that implementation of a nationwide EHR network would take about 15 years and cost hospitals about $98 billion and physicians about $17 billion.  Over the 15-year period, the average annual cost to hospitals would be $6.5 billion and the average annual cost to physicians would be $1.1 billion (CQ HealthBeat [1], 9/14). However, if 90% of providers adopted such a network, annual savings would total $81 billion, including $77 billion from improved efficiency and $4 billion from reduced medical errors, the RAND study found.  The study estimates that an EHR network would reduce adverse drug events in inpatient hospital settings by 200,000 annually and reduce such events in ambulatory settings by two million annually, saving $1 billion annually in hospitals and $3.5 billion in ambulatory settings.  For hospitals, about 60% of these savings would be from reduced adverse drug events in patients ages 65 and older, while 40% of savings to ambulatory practices from reduced medication errors would be in patients 65 and older (CQ HealthBeat [1], 9/14).

Assessment

In addition, the study estimates that a national EHR network would save Medicare about $23 billion annually and save private insurers about $31 billion annually.  The study projects that the estimated total annual savings of $81 billion would double if providers followed all checkup reminders and other prompts from the system (AP/Las Vegas Sun, 9/14).  Currently, about 20% to 25% of hospitals and 15% to 20% of physician offices have EHR systems, according to the study (CQ HealthBeat [1], 9/14).

But, what is the estimated cost in 2010?

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Conclusion

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References:


[1]    For details of the report, see http://www.oecd.org/dataoecd/29/52/36960035.pdf.

[2]   OECD, Towards High-Performing Health Systems, see http://www.oecd.org/document/26/0,2340,en_2649_37407_31734042_1_1_1_37407,00.htm.

[3]   See http://www.rand.org/health/feature/2006/060414_shekelle.html.  The report is also discussed in some detail in Neergaard, AP/Las Vegas Sun, 9/14/05.  See http://www.ihealthbeat.org/index.cfm?Action=dspItem&itemID=114707.

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