Don't Be Dumb with Rules of Thumb (This Means DON'T USE THEM!)
Rule #1 - Percentage of Receipts
Solo Practice
This rule only works if the practice being valued has characteristics similar to the average practice in the market. For example, if the rule of thumb for a "good" solo practice is 40% of receipts and the average solo practice has $300,000 of revenue, a practice with only $200,000 will not be worth $80,000. By the same token, a practice doing $500,000 in receipts, all things being equal, may be worth more than 40% of receipts. The size of the practice is indicative of its revenue earnings capability, particularly in terms of numbers of patients available for conversion to capitation.
Group Practice
For a strong group practice, the rule of thumb might be 60% of receipts. Again t, this assumes that the group meets the standard of the typical group practice in the market area. Groups generally have ancillary income (lab, xray, etc.) and therefore the receipts per physician will be higher than for a similar number of solo providers. For example, if a group has 10 physicians and does only $3.0 million in receipts - $300,000 from above times 10, it is likely to be underperforming and therefore will not draw the market ceiling of 60% in a valuation. If it is doing $4.0 million, it may be an excellent acquisition target - or, it may be overusing ancillaries. The valuation consultant can only assess the relevant of the rule of thumb through the underlying analysis of the practice.
Rule #2 - Price per FTE Physician
Solo Practice
Values are often quoted in terms of dollars per FTE, e.g., $120,000 for a solo practice. This has become increasingly common in trade publications, and is a bad trend in our opinion. Again, this must be seen in light of the Percentage of Receipts rule and the underlying analysis. A practice with $200,000 in receipts is not likely to be worth $120,000, or 60% of one year's income - it violates the first rule. This can also be explained by focusing ion the expression FTE. This contemplates a full-time equivalent, i.e., someone who generates an amount of revenue comparable to the standard a full practice. $200,000 is not he equivalent of an 1.0 FTE practice.
Group Practice
$300,000 is the quoted upper end in our market of price per FTE physician in a group. What is a group practice? Do three physicians constitute a group? Five? In our view, this number is more appropriate for ten or more physicians. At 25 or 30, the number may, in fact, increase. If the practice has successful risk capitation experience, it may be yet higher. Clearly, a three person practice is not a risk bearing entity for global capitation, whereas a 20 person practice may well be. Large valuation can only be supported through the profit stream inherent in successful risk management.
Rule #3 - Percentage of One Year's Net Income
Solo Practice
A typical rule of thumb is 100% of one year's net for a solo practice. This rule is closely connected to the first rule of 40% of one year's receipts. Why? The typical margin in a practice is 40% of receipts, with overhead at 60%. Incomes that are less than or more than the usual will likely value differently than this standard.
Group Practice
The rule of thumb is also 100% of one year's net for a group practice. The bottom line is indicative of its historical earning power and valuation is, after all, the measurement of the worth of a stream of future earnings. Yet again, incomes that are less than or more than the usual will likely value differently than this standard, particularly if a large component of fee-for-service ancillary income is present.
Conclusion
Rules of thumb are useful in assessing a properly prepared quantitative valuation only when the user understands how the rules have been arrived at and how to measure whether the valuation subject compares to the "standard" practice inherent in the rule.
