Establishing the value of goodwill using the excess earnings method

The financial value of a medical practice is composed of two parts:

1. “Goodwill” — an intangible value associated with the name and reputation of the medical practice
2. The current value of the hard assets (clinical, administrative and IT equipment) of the practice, not including real estate. The valuing of hard assets is fairly straightforward, but the value of goodwill is difficult to assess objectively.

The two most common methods of establishing the value of goodwill have significant drawbacks. The comparable sales and income approaches are complex, often based on data spanning several years and geographic areas, and sometimes use a discount rate to value future cash flows that may not be accurate in a time of fluctuating interest rates. 

The excess earnings method is a simple and easily understood way of establishing the value of goodwill specific to the practice, focused on a point in time (generally the end of the most recent fiscal year), and is less subjective than other methods. It is based on the concept that the value of goodwill is equal to the difference in total compensation paid to current owner and the compensation of a new physician starting practice out of residency.

Owner physician total compensation

The total compensation for an existing (selling) physician is set as the value of salary plus bonus plus distributions plus the practice’s share of the physician’s FICA (Social Security plus Medicare) tax plus “personal expenses (practice-provided benefits in excess of basic health insurance and medical education compensation).” This information can be found in federal income tax filings (Schedule C for an individual owner) and the practice’s internally produced financial statements.

Personal expenses include all benefits paid (in full or part) to the owner by the practice in excess of what a new physician would receive. These are added into the value of the owner physician’s compensation. Examples of such benefits are an automobile allowance, personal disability insurance and key person insurance.

New physician compensation calculation

The average total compensation for a new physician of the same specialty can be accessed through the 2019 MGMA DataDive Provider Compensation in the Provider Placement Starting Salary dataset. It contains a section titled, “First Year Post-Residency” with mean and median compensation figures. This report is produced annually, with published salary levels one year in arrears. To compensate for this one-year lag in current compensation, an inflation factor (also available from MGMA) from the prior year can be used to estimate the current market-based compensation.  

For example, for family practice (without OB), the median compensation1 based on 2018 data was $205,000. The percentage change in compensation from the prior year (2017) was 2.5%. Updating the 2018 compensation using the 2.5% prior year inflation figure yields a new physician median compensation for 2019 of $210,000 (rounded). To this amount should be added the practice’s share of the FICA tax.

An example calculation for goodwill

As an example, Dr. Smith, a family practitioner (no OB), was compensated in 2019 as follows:

The above example sets the value of goodwill at only one times the excess earnings. For purposes of setting the price of a practice for a sale, it is common to set the value at a multiple of year one, based on the premise that most medical practices starting from day one will not be as profitable as a mature practice until at least three years of operation. Using a two- or three-year multiple is common.

When projecting the value of goodwill, it is important to examine the expenditures of the medical practice to eliminate any one-time expenses that will not be repeated within three years after the sale, add in any missing material expenses not included in the financial statements and add any major future expenses necessary to continue the practice producing at the same level as the base year.

Involve an accountant

It is important to involve the practice accountant at the beginning of the process. This individual should have insight into the items in the depreciation schedule and can advise on the tax effect on depreciable assets for the purchaser. For example, it is important to understand that goodwill must be amortized over 15 years, but most equipment can be depreciated over one year using the accelerated depreciation rules.

Note:

1. MGMA. 2019 MGMA DataDive Provider Compensation.