More Thoughts on Exclusive Reliance on the Cost Approach

July 3rd, 2011 | Cost Approach | Income Approach & Methods | Market Approach | Regulatory Matters | Valuing Goodwill

Despite the White Paper co-authored by members of a number of leading healthcare valuation firms, there continues to be an inexplicable insistence that a collection of assets that have no net cashflow or income and cannot be re-sold to another hypothetical investor have a “fair market” value.

Among the many flaws in reasoning in the Cost Approach as in current use for medical practices are failure to account for two elements that underlie the definition of fair market value. The first of these is the “financial buyer” standard, i.e., that the hypothetical investor of the fair market value standard is primarily interested in income returns. This can be readily read in many textbooks such as Pratt or those by Chris Mercer.

Perhaps even more basic than the definition of the hypothetical buyer is the meaning of the word “market.”
The “market” in fair market value is conceptually based on the stock market, as can be seen in Revenue Ruling 59-60. “When a stock is closely held, is traded infrequently, or is traded in an erratic market, some other measure of value must be used. In many instances, the next best measure may be found in the prices at which the stocks of companies engaged in the same or a similar line of business are selling in a free and open market.” The rates of return used to value companies are derived from data such as that in Morningstar (Ibbotson) based on publicly traded stocks. In the stock market, of course, the value of a stock is what it is sold and purchased (both) for at a given time.

Of critical import here is that I can both buy and sell a stock for the same amount, and that is precisely where the Cost Approachers fail to think through their methodology. As the White Paper indicates, there is no evidence that a hospital paying for physician workforce in place could turn around and sell that workforce in place back to the physicians, violating the equivalence requirement between buyer and seller inherent in the “market” of fair market value. For other purportedly valuable intangible assets based solely on the Cost Approach, a similar analysis must be undertaken: Can the purchasing hospital sell the asset to another buyer at the same time for the same amount? The inability to do this is precisely what the underlying theory of marketability and liquidity discounts is based on. When the fair market value of an asset is determined, one MUST consider the cashflow stream from it, whether that cashflow be in the form of sales proceeds or current income returns.

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