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Financial Fundamentals of Medical Practice Sales
Dr. David Edward Marcinko; MBA, CMP™
SPONSOR: www.CertifiedMedicalPlanner.org
A physician investor’s required rate of return [RoR], 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 risk-less 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 and can be adjusted for 2024.
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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OUR OTHER PRINT BOOKS AND RELATED INFORMATION SOURCES:
- HOSPITALS: http://www.crcpress.com/product/isbn/9781466558731
- CLINICS: http://www.crcpress.com/product/isbn/9781439879900
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- BLOG: www.MedicalExecutivePost.com
- FINANCE: Financial Planning for Physicians and Advisors
- INSURANCE: Risk Management and Insurance Strategies for Physicians and Advisors
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Filed under: Practice Management, Practice Worth | Tagged: Healthcare Business Valuation, medical practice sale, rate of return, risk premium. |
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Follow-Up on Private equity
Private equity is currently in the news, but generally available only to accredited investors. The relative lack of efficiency in this market allows the investors and endowment to seek superior risk-adjusted returns by participating in such investments as venture capital and leveraged buy-out funds.
When investing in this asset class, the endowment manager, physician or investor would be well served to partner with managers who “emphasize a value-added approach to investing. Such firms work closely with the portfolio companies to create fundamentally more valuable entities, relying only secondarily on financial engineering to generate returns.”
Now, although this class of investments has handsomely rewarded many large endowments and astute investors, the manager must also remember that the very nature of this class is such that liquidity may be very limited.
Dr. David Edward Marcinko; MBA, CMP™
http://www.CertifiedMedicalPlanner.com
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