How to Use EBITDA Multiples In a Medical Practice Valuation

As a medical practitioner, have you ever wondered about the buzz surrounding private equity firms acquiring medical practices? Perhaps you’ve heard colleagues discussing mysterious “EBITDA multiples” and their impact on practice valuations. If so, you’re not alone, and you’ve come to the right place for answers.

In this blog post, I’ll demystify the concept of EBITDA multiples and their role in medical practice valuations. I’ll cover what EBITDA is, why it’s used, how to calculate it for a medical practice, and provide a real-world example of an EBITDA multiple valuation.

Understanding EBITDA

What is EBITDA?

EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortization. It’s a financial metric used to evaluate a company’s operating performance without the influence of certain financial and accounting decisions or tax environments.

Why Use EBITDA?

EBITDA has gained popularity as a valuation metric for several reasons:

1. Operational Focus: By excluding interest, taxes, depreciation, and amortization, EBITDA provides a clearer picture of a company’s operational efficiency and core profitability.
2. Comparability: EBITDA allows for easier comparison between companies with different capital structures, tax rates, or depreciation policies. This is particularly useful when comparing medical practices of varying sizes.
3. Cash Flow Proxy: While not perfect, EBITDA is often used as a rough approximation of cash flow, which is crucial in valuing businesses.
4. Acquisition Suitability: For buyers, especially private equity firms, EBITDA helps in assessing a practice’s ability to service debt after an acquisition.

However, it’s important to note that EBITDA is not without its critics. Warren Buffett and Charlie Munger, renowned investors, have famously criticized its use. Warren argued that it can obscure real financial performance by ignoring real costs.

Despite this criticism, EBITDA remains a popular metric, especially in the world of private equity acquisitions in healthcare. The healthcare sector, including medical practices, has seen a significant influx of private equity investment in recent years.

According to a report by Bain & Company, healthcare private equity deal volume has grown substantially over the past decade. In 2012, there were approximately 195 healthcare private equity deals globally. By 2022, this number had nearly doubled to 353 deals. This trend underscores the increasing relevance of understanding EBITDA and its multiples in medical practice valuations.

Private equity firms have become major players in healthcare, particularly in areas like dermatology, ophthalmology, and dental practices. Their strategy often involves acquiring multiple practices, consolidating operations, and then selling the larger entity at a higher valuation. This approach has made EBITDA multiples a common language in practice acquisitions.

Calculating EBITDA for a Medical Practice

When it comes to medical practices, we can’t simply use historical EBITDA figures. Instead, we need to normalize EBITDA to reflect the true operational performance of the practice. Here are some common normalization adjustments:

1. Discretionary Expenses: Personal auto and travel expenses often need to be adjusted.
2. Rent: If the practice space is owned by a related party, rent may need to be adjusted to market rates.
3. Family Member Compensation: If family members are employed by the practice, their compensation may need to be adjusted to market rates.
4. Non-recurring Income: Items like COVID-19 relief funds (HHS payments or PPP loans) should be eliminated as they are non-recurring.
5. Owner Compensation: This is a crucial and often complex adjustment for medical practices. Physicians typically play dual roles as both owners and providers/employees. To determine the true return on ownership, we need to adjust the owner’s compensation to a fair market level. This adjustment is not straightforward and requires in-depth knowledge of the medical field and billing practices. A valuation professional needs to:
   • Understand the specific role the physician plays in the practice
   • Analyze the physician’s productivity, often using metrics like work RVUs (Relative Value Units) and collections
   • Compare compensation to industry benchmarks for similar specialties and geographic areas
   • Review billing reports to understand the patient volume seen by the physician
   • Consider any management or administrative duties performed by the physician-owner
6. For example, if a dermatologist-owner is paid $800,000 per year, but the market rate for a dermatologist with similar productivity in the same area is $600,000, we would need to add back $200,000 to the practice’s EBITDA. This adjustment reflects the “excess” compensation that’s actually a return on ownership rather than payment for services. It’s important to note that this adjustment can significantly impact the EBITDA figure and, consequently, the practice’s valuation. Therefore, it requires careful analysis and often benefits from the expertise of a healthcare valuation specialist.

Common Normalization Adjustments
Income:	Expenses:
– PPP Loan Income	– Officer’s Compensation
– HHS Stimulus	– Family Compensation
– Non-Recurring Bonuses	– Rent
	– Retirement Plan Contributions
	– Auto
	– Travel

Understanding EBITDA Multiples

An EBITDA multiple is a valuation ratio that compares a company’s value to its EBITDA. In the context of medical practices, EBITDA multiples are frequently used to determine practice values, especially in acquisition scenarios.

What Does an EBITDA Multiple Represent?

A common misconception that I encounter is about what the resulting value from an EBITDA multiple represents.  Value or price in the mind of a seller usually means value of equity in a business. Because EBITDA as a benefit stream includes both, the cash flow available to equity holders and debt holders, an EBITDA multiple should be matched up to the Market Value of Invested Capital (MVIC).  MVIC is equal to the value of shareholder’s Equity plus Interest-Bearing Debt.

For example, if you buy a practice for $5 million in cash and also assume $1 million in long-term debt, you’ve effectively paid $6 million for this practice. This total amount ($6 million) represents MVIC and what the EBITDA multiple should be matched to.

Understanding this distinction is crucial when using EBITDA multiples in practice valuations to ensure you’re comparing apples to apples.

How EBITDA Multiples Work

The EBITDA multiple formula is:

Market Value of Invested Capital = EBITDA × EBITDA Multiple

As mentioned before, Market Value of Invested Capital = Equity + Interest-Bearing Debt. Interest-bearing debt includes short-term notes and long-term debt. 

For example, if a practice has an EBITDA of $500,000, interest-bearing debt of $800,000 and is valued at an EBITDA multiple of 6, its MVIC would be $3 million, and its Equity would be worth $2.2 million.

Factors Affecting EBITDA Multiples

Several factors can influence the EBITDA multiple for a medical practice:

1. Specialty: Some medical specialties command higher multiples due to factors like growth potential or consolidation trends.
2. Geographic Location: Practices in desirable locations may fetch higher multiples.
3. Growth Rate: Practices with higher historical and projected growth rates often warrant higher multiples.
4. Size: Larger practices often command higher multiples due to economies of scale.
5. Payer Mix: A favorable payer mix (e.g., more private insurance vs. Medicare/Medicaid) can lead to higher multiples.
6. Infrastructure and Technology: Practices with modern, efficient operations may be valued at higher multiples.

EBITDA Multiples in the Market

Different buyers may be willing to pay different multiples based on their own strategies and goals. Private equity firms, for instance, often aim to acquire practices at a certain multiple with the intention of growing the practice and reselling at a higher multiple later.

It’s important to note that EBITDA multiples can vary widely. In recent years, EBITDA multiples for medical practices have generally ranged from 4 to 12, with some high-growth specialties or platform acquisitions commanding higher multiples.

EBITDA Multiple Valuation Example

To illustrate how EBITDA multiples work in practice, let’s walk through a valuation example for a solo dermatology practice. We’ll use the following formulas:

1. MVIC = EBITDA × EBITDA Multiple
2. MVIC = Equity + Interest-Bearing Debt

Step 1: Gather Financial Information

First, we’ll collect relevant financial information from the practice’s S corporation tax return. Here’s a table summarizing the key data:

Item	Amount	2023 Form 1120-S Line Number
Officers Compensation	$450,000	Line 7
Rent	$120,000	Line 11
Interest	$10,000	Line 13
Depreciation	$50,000	Line 14
Net Income	$300,000	Line 21
Amortization	$5,000	Part of Line 20 (Other Deductions Schedule)
Auto Expenses	$12,000	Part of Line 20 (Other Deductions Schedule)

Step 2: Establish Assumptions

Next, we’ll establish some key assumptions for our valuation:

1. Interest-Bearing Debt: $200,000
2. EBITDA Multiple: 4.0 (based on market data for similar dermatology practices)
3. Normalization Adjustments:
   • Auto Expense Add-back: +$12,000 (personal use of vehicle)
   • Rent Adjustment: -$20,000 (current rent is below market rate)
   • Officer’s Compensation Adjustment: +$50,000 (current compensation is above market rate)

Step 3: Calculate Normalized EBITDA

Now, let’s calculate the normalized EBITDA:

1. Start with Net Income: $300,000 (already pre-tax)
2. Add back:
   • Depreciation: +$50,000
   • Amortization: +$5,000
   • Interest Expense: +$10,000
3. Adjustments:
   • Auto Expense Add-back: +$12,000
   • Rent Adjustment: -$20,000
   • Officer’s Compensation Adjustment: +$50,000

Normalized EBITDA = $300,000 + $50,000 + $5,000 + $10,000 + $12,000 – $20,000 + $50,000 = $407,000

Step 4: Apply EBITDA Multiple

Now we can apply our EBITDA multiple to get the Market Value of Invested Capital (MVIC):

MVIC = Normalized EBITDA × EBITDA Multiple

MVIC = $407,000 × 4.0 = $1,628,000

Step 5: Calculate Equity Value

To find the equity value, we subtract the Interest-Bearing Debt from the MVIC:

Equity Value = MVIC – Interest-Bearing Debt 

Equity Value = $1,628,000 – $200,000 = $1,428,000

Conclusion of Example

In this example, using an EBITDA multiple approach, we’ve determined that:

• The Market Value of Invested Capital (MVIC) for this dermatology practice is $1,628,000
• The Equity Value of the practice is $1,428,000

It’s important to note that this is a simplified example. In a real-world valuation, we would typically:

1. Use multiple valuation methods and reconcile the results
2. Perform a more detailed analysis of the practice’s financial statements and operations
3. Consider additional factors such as the local market conditions, growth potential, and specific risk factors associated with the practice

This example demonstrates the process of using EBITDA multiples in practice valuation, including the critical steps of normalizing EBITDA and distinguishing between the value of invested capital and equity value.

Conclusion

Understanding EBITDA multiples is crucial in today’s healthcare market, where private equity acquisitions are becoming increasingly common. While EBITDA isn’t without its critics, it remains a widely used metric in practice valuations.

Remember, calculating EBITDA for a medical practice involves several normalization adjustments, particularly regarding owner’s/officer’s compensation. When using EBITDA multiples, ensure you’re matching the multiple to the correct value definition (typically MVIC).

As with any valuation method, EBITDA multiples should be used in conjunction with other valuation approaches to get a comprehensive view of a practice’s worth. If you’re considering selling your practice or are simply curious about its value, consulting with a qualified valuation professional can provide invaluable insights.

If you are interested in a deeper dive into practice valuation, watch my FREE Webinar on the three valuation approaches used to value doctor practices.