BY ERIC MEERMANN and TIMOTHY MEYER
How much is a professional practice worth? It takes detailed analysis to get a credible number.
The first step in establishing value is determining the standard of value, which includes defining the valuation”™s “subject interest” ”“ what”™s being valued, that is, such as an entire business or a percentage ownership in it ”“ and how it will be valued.
There are two main standards of value. “Fair market value” is defined by the IRS as “the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell and both having reasonable knowledge of the relevant facts.” Another standard, “liquidation value,” is the value of the business”™s assets if someone were to liquidate it. This usually produces a lower value than fair market value since intangible assets are excluded.
Next, define the valuation date. This is important because fluctuations in the value of a corporation”™s assets and liabilities will affect the net asset value of the subject interest. Additionally, changes in economic and market conditions can influence the price a buyer would be willing to pay.
A valuation analyst must conduct business-specific research, including evaluating the operations of the business and digging into its financial statements. Economic research is also crucial. The health of the local economy affects value.
Industry trends also factor into value. Suppose the practice is a doctor”™s office in rural upstate New York. What is the current state of the healthcare industry? What are typical wages of physicians, nurses and administrative assistants? It”™s also important to ensure that the valuation is up-to-date with new laws and regulations.
What are the demographics of rural upstate New York? Is the population aging? How often do people in the area visit the doctor”™s office? What is the median income?
Next, get into the practice itself. Analyzing the organizing documents of the business reveals the shareholders”™ freedoms and limitations. Some may include rules permitting only a certain number of shareholders at one time or banning the sale of shares without consent of the other shareholders. These will affect the valuation.
At least five years of financial statements are usually necessary. Determining where the business”™ revenue comes from and where its expenses are incurred, as well as the consistency of these figures, will yield a more accurate valuation.
Financial statements can be inconsistent over time because of fluctuations in the market, changing demographics, larger-than-normal expenses related to new technology and so on. Because of these inconsistencies, the statements must be adjusted to match current market conditions and market averages. This could mean changing the value of assets to their current market value or moving salaries toward the annual mean for people who hold similar positions.
Valuation: Three approaches
Once all the research has been gathered and adjustments have been made, the valuation can commence. There are three approaches for obtaining the final number: asset, market and income.
The principle of substitution underlies both the asset and the market approaches. It states that a buyer would not pay more for an asset than it would cost to acquire or create another asset that would provide equal or greater economic benefit.
The principle of future benefits underlies the income approach. It states that a buyer would not pay more for an asset than the current value of the future benefits that the buyer expects to obtain from holding the asset. The current value must be calculated by referring to a rate that recognizes both the time value of money and the risk, or uncertainty, that the buyer will receive the expected stream of benefits.
The adjusted net-asset method, one example of the asset approach, determines the value of a business based on the difference between its liabilities and the fair market value of the business”™s asset, including its employees, customers and business systems.
For small service companies, such intangible assets are difficult to value without reference to completed sales of similar practices. In the absence of concrete data by which to value the company”™s assets, this methodology can create misleading results. The asset approach to business valuation can also greatly distort the fair market value of an operating business because it gives no consideration to the value of future earnings.
The market approach uses market data on the sale of comparable companies, often in the form of earnings or revenue multiples, to determine a company”™s value. This method expresses a relationship between the estimated future amount of net earnings and the estimated value of the business.
Market multiples, such as a price/earnings ratio or a price/EBITDA (earnings before interest, taxes, depreciation and amortization) ratio, are compared with those of similar companies to determine the subject interest”™s value. While this method is a great way to estimate the value of big, diversified businesses, it is difficult to use to compare small, private companies.
Income approach usually best
The income approach is usually most appropriate in determining the value of an asset that provides its owner with direct access to future cash flows, such as a professional practice.
The most widely used income approach is the discounted earnings method, also known as the discounted cash-flow method. First, the valuator must determine the estimated future earnings of the business (usually for the next five years). This can be done using the adjustments to the income statement and applying an average growth rate to the projected future earnings.
Second, the analyst must determine a terminal value for the business at the end of the fifth year. Then, a discount rate can be established. It should incorporate the principle that investors require a greater return on riskier classes of assets. Finally, the estimated future earnings and the terminal value are discounted to the current value and summed using the discount rate. This figure is the total value of the business.
When the valuation is complete, discounts must be applied in certain situations. Consider a business worth $10 million that has one shareholder. The shareholder wants to sell 30 percent of the business and retain the other 70 percent. Although the pro rata value of 30 percent of this business is $3 million, that figure would not be the fair market value. The original owner still holds the majority of the shares, so he will have the final say in all decisions. A discount for lack of control would need to be applied for the 30 percent interest in the company to be appealing to a buyer. Such a discount could range from 10 percent to 30 percent or more.
Further, since this is a private company, there is no readily available market for its shares. Therefore, another discount would need to be applied to account for the inability to quickly turn the investment into cash. This discount could be around 30 percent, but courts have supported discounts far higher than that for lack of marketability.
After determining the value of the company, applying the ownership percentage of the subject interest and applying any relevant discounts, the valuation analyst has finally arrived at the opinion of value.
Eric Meermann, a certified valuation analyst and certified financial planner, is a client service manager and portfolio manager with Palisades Hudson Financial Group in Scarsdale. Timothy Meyer is a financial analyst with the firm. They can be reached at 914-723-5000 or by email at eric@palisadeshudson.com or tim@palisadeshudson.com.
