The Excess Earnings Method

Historically, professional practices have generally been valued by use of the excess earnings method. This approach makes sense in the professions and service businesses because acquisition of an equity interest leads to higher income than earned as an employee (all things being equal!).

The method is commonly used in many types of business valuations and is accepted by the courts and the IRS. However, the Friendly Hills and Harriman Jones Exemption rulings, in addition to public statements by the IRS and the Continuing Education Handbook, have made the discounted free cash flow method the standard. Does the excess earnings method remain relevant?

The underlying difficulty with use of the excess earnings method in a medical practice acquisition by a hospital or other institution with continued employment is the salary and benefits paid to the selling physician. Many transactions provide the seller will be paid a salary equivalent to that earned in the period preceding the sale. This raises the spectre of zero excess earnings and no value!

Valuator's typically determine excess earnings by subtracting a base earnings number from actual earnings. Base earnings are determined by reference to statistical sources such as the MGMA. Often, the median or mean earnings are used, as would be the case in a traditional sale to another physician. This, the author believes, is the core of the IRS' objections to the method. This objection can be "cured" by using compensation negotiated as part of the transaction to compute the excess earnings. This certainly seems consistent with the IRS' desires, though it may run afoul of the "fair market value" standard.

A better approach, in the author's view, is to examine carefully what the buyer expects to receive in additional revenue from the transaction. Historical earnings should then be normalized for these additional future earnings. Excess earnings could then be based on compensation paid post transaction or, preferably, on a statistical measure of compensation for an experienced physician, such as the seventy fifth percentile earnings, or whatever the valuator finds relevant to the analysis. To recap, normalize historical earnings for future increases, then use fair market value earnings for the seller. (The normalization adjustment should be determined by reference to market factors, such as capitation profits, especially in Medicare, and other sources of growth in the practice. Additional revenue to the buyer which would be in violation of stark of fraud and abuse statue and regulations, should NEVER be considered).

Another issue in the use of this method is whether or not an allowance for a return on tangible assets should be deducted in computing excess earnings. The standard application of the excess earnings method requires such a reduction. However, physicians generally take all of their income out of the practice as compensation. Statistical sources therefore reflect the return of tangibles as part of physician compensation. Deducting it again would be double counting.

A wise man once told me that every valuation should be prepared with the expectation that it will be reviewed by a court. The author believes that the allowance for a return on tangibles should be deducted. The statistical physician earnings should be adjusted to avoid the double counting of tangible asset return. The presentation of the method will then be consistent with the generally accepted manner of performing it.

What should the rate of return on tangible assets be? This is a difficult question. In the author's view, the required rate of return should be determined by reference to the practice's cost of debt, with a potential adjustment to reflect personal guarantees or collateral. The rationale for this approach is as follows: The principle tangible assets in a medical practice are 1) Accounts receivable, and 2) Furniture and Equipment. If the practice has debt, it will typically be incurred for working capital or to finance furniture and equipment. Working capital loans are usually on demand at a rate floating with prime, secured by the accounts receivable. Furniture and equipment can often be financed on a fixed rate, fixed term basis of 24 to 60 months, with the lender taking a collateral interest. In the author's experience, the interest rates on both types of loans range from 9.25% to 12%. If the presence of personal guarantees is critical to the loan, the valuator should consider adding to the rated a charge for the personal guaranty, similar to that for a letter of credit accommodation.

Conclusion

If properly prepared with normalization adjustments and relevant base earnings, the excess earnings method should represent a useful valuation tool. The normalization process in an excess earnings model can be likened to the forecast of future earnings required in the discounted free cash flow method. Ideally, both methods should be used to provide a cross check of the other's results.

Look for upcoming articles by Mark in the CPA Health Niche Advisor. Visit their web site at http://www.hbpp.com/healthniche/index.html

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    Mark O. Dietrich
    dietrich@cpa.net
    last revised July 10, 2000
    Copyright Mark O. Dietrich, Dietrich & Wilson 2000 all rights reserved