From VMG Health, by Dylan Alexander, CVA and Gerrit Elzinga, CVA:
As of January 2024, there are over 338,000 physician group practices in the U.S. The compensation structure for shareholder physicians, which often changes during business transactions, plays a significant role in the valuation of a practice. Higher post-transaction physician compensation typically results in a lower valuation for the practice due to less available earnings.
Physician compensation can take multiple forms, including salaries, benefits and payroll taxes, discretionary expenses, and other forms of compensation such as profit sharing and distributions. The compensation levels vary from practice to practice and are a vital factor in determining the earnings available for transactions.
The profitability of a practice, which influences the available compensation, is determined by factors such as physician productivity, reimbursement rates, ancillary service offerings, and effective use of mid-level providers. Expense management is also critical, as practices with high operating expenses are less profitable.
Three main valuation methods are used for physician practices: income approach, market approach, and cost approach. Both the income and market approaches are sensitive to the level and structure of physician compensation. Lower compensation levels can increase projected free cash flows and the earnings multiple, thus increasing the practice’s valuation. However, compensation should align with market levels to avoid sustainability risks.
Physician practices have the autonomy to determine their service offerings, providers, and compensation structures. Understanding the relationship between post-transaction physician compensation and the fair market value of a practice is crucial for both buyers and sellers, as it significantly impacts the practice’s valuation.