So, you want to buy your own practice? Congratulations! You’re plunging into the deep end of the pool. Let’s make sure you know enough to keep your head above water so you can enjoy the dip rather than…well, you know.

There are many things you need to think about when you’re buying your own practice: price, business plan, location, dealing with insurance companies, marketing, and more. In this article, we’re going to focus on what is probably your main concern: price.

It’s tricky to determine what the appropriate price is to pay for a practice. Let’s take a look at some of the main valuation approaches used.

Comparable sales

The comparable sales method looks at the prices paid for other similar practices in the area. The appeal of this method is that it’s easy to use. The problem with this method is that sales price data are hard to come by because most sales are confidential. It’s also problematic because every practice is different: size, location, specialty, and local competition are just some of the differences. Assuming you have access to the sales price data, it can serve as a reference point, but it shouldn’t be relied on for more than that.

Valuation Multiples

Valuation multiples are appealing because they provide rough rules of thumb for how to value a practice. Usually, you’ll look at what the business has done over the past three years and then you’ll look at different financial ratios, such as “sales price to revenue,” “sales prices to book value,” or “sales price to free cash flow.” For example, if the revenue over the past three years has averaged $3 million and the price being asked for the practice is $3.3 million, the price to sales ratio is 1.1x ($3.3 million offer/$3 million revenue=1.1).

Multiples vary and change over time. Twenty years ago, the range was 1.5x-3.0x gross annual revenue but that range has narrowed to 1.5x-2x. And remember: this is just a rule of thumb. The problem with “rules of thumb” is that they aren’t definitive. Treat them as guidelines that you’re in the ballpark and leave it at that.

Ultimately, you also have to consider a number of qualitative factors, such as location, physical condition of the office, the local competition, the likelihood that you’ll be able to retain the physician’s patients, and more.

Assets

Another way to value a practice is by its assets. The appeal here is that it’s relatively easy to determine the value of many of the practice’s assets. Some of these include: the office’s cash in the bank, accounts receivable, equipment, computers, office supplies, and the office itself. It also includes goodwill—which can be harder to quantify.

Goodwill is challenging to value because it’s an intangible asset. In a well-known company such as Coca Cola, there is arguably value to the Coca Cola “brand” – it’s well-known and loved by many. The value of Coca Cola’s brand is included in goodwill and a potential acquirer of the company would be forced to pay a significant premium for that. In a medical practice, goodwill might include aspects such as the selling doctor’s reputation and relationship with their patients, location, and profitability. These are a little trickier to value and the seller will likely place a higher value on goodwill than the buyer.

Discounted cash flow

The most popular method used is discounted cash flow. Cash flows are different than net income. A business’s financial statements consist of three main items: an income statement, a balance sheet, and a statement of cash flows. The statement of cash flows reconciles the income statement and the balance sheet. When you hear “cash flow,” this usually means “free cash flow,” which is net income adjusted for non-cash expenses, changes in working capital, and capital expenditures. The simplest way to calculate it is to take total cash flow from operations, add back interest expense, and subtract capital expenditures (money spent on things like equipment purchases).

When it comes to valuing a business using discounted cash flows, you have to estimate future cash flows. Essentially, you’re making a forecast for how the practice will do financially for the next 5-10 years, which differs from the multiples method, which looks at what the practice has done in the past.

So, let’s say our cash flow is $200,000 in year one and it grows 3% each year. If we assume that our required discount rate (the rate we need to earn to make this investment worthwhile) is 15%, the 10-year stream of cash flows and discounted cash flows look like this:

In order to discount the cash flows, you can either use the present value (PV) function in excel (=PV) or a present value calculator on the internet. Note: you have to discount each year separately and then add them up. For example, to get the discounted cash flow from year five in the table, the $225,102 of cash flow is the “future value” or “FV,” the discount rate of 15% (or whatever rate you choose) is the “rate,” and the “nper” or “period” is “5,” which should deliver the discounted cash flow of $111,915.

In excel, the PV function looks like this: =PV(rate, nper, pmt, [fv], [type])

And you would fill it in like this: =PV(15, 5,0,225102).

Once you’ve discounted all the cash flows and added them up, if the sum of the discounted cash flows are more than the price for the practice, then the price being asked is reasonable and you should consider taking it. If not, you could negotiate to see if the seller would be willing to lower the price.

Summary

Calculating the value of a business is difficult, but not impossible. You can try and do it on your own, but you may have difficulty getting access to the data you need and making all the calculations and comparisons might you take you some time. It might make sense to consult an industry expert who specializes in buying and selling medical practices, as the cost of their services could very well save you a lot of money now, and in the future. They’ll have access to the right data, as well as a sense of what the proper valuations are, and might be able to help you gauge the qualitative factors as well.