Practice valuations are very complicated and can involve multiple methods by people with highly variable experience.38-41 The main driver of valuations remains the actual revenue or collections in the practice and related owner profit (which obviously takes overhead into account) using practice financial data for the past 3 to 5 years. In our opinion, multiple valuation methods should be utilized, including capitalization of earnings, excess earnings and asset summation. While a thorough discussion of practice valuation issues clearly exceeds the scope of this course, a brief overview of the three methods just mentioned, plus a commonly misused “ballpark” approach, will enable you to have a greater appreciation for the complexity of practice valuation issues.
- Capitalization of earnings involves calculating a rate of a return on the practice’s profits, with the rate of return referred to as the “cap rate.”38-41 What dollar amount is used to determine the rate of return? The “excess earnings” of the practice which, simply defined, is the cash remaining AFTER paying all expenses PLUS a reasonable compensation for dentist-related labor costs (often in the neighborhood of 25% of generated revenue +/- 5 to 10%). The cap rate or rate of return is somewhat subjectively determined by an appraiser but often hover in mid-twenties range. A potential buyer must recognize the cap number greatly influences the asking price. The lower the cap rate in the formula, the higher the valuation and vice-versa. The formula appears fairly simply, but arriving at the values to enter into the formula represent a complicated process:
For example, if the excess Earnings = $100,000 and the Cap Rate = 28%, the practice value would be $357,143 ($100,000 divided by .28 = $357,143). Note if the Cap Rate drops to .25, the practice value would be $400,000 ($100,000 divided by .25 = $400,000).
- Excess Earnings. This is a cousin to Capitalization of Earnings. The goal here is to determine how much debt excess earnings would allow a new owner to pay off. This is analogous to a home loan amortization schedule. At 6% interest over a 7 year period, a buyer would have to make the payments of $5,843 per month for a $400,000 practice. The question would then be: are there sufficient revenues being generated in the practice in order for the owner to cover all the overhead costs plus have enough revenue for working capital and to meet personal/family budgetary needs? Lenders may answer this question by a debt- to-service ratio—simply stated, this compares excess practice earnings to personal budgetary needs. The practice revenue must cover the overhead and practice loan payment to guard against potential unexpected business or personal expenses. For example, if a buyer has to realize a minimum of $100,000 annually for his/her personal budget, excess earnings from the practice should usually be ~1.25 above $100,000—namely, ~$125,000.
- Asset Summation is a very sophisticated process in which practice appraisers research, assign a value to, and sum all assets in a practice. Assets are assigned values for variables such as computer systems, radiology equipment, patient records, location, demographics, profitability, staff experience/loyalty and cash flow.
- Revenue Multipliers. Most general dental practices will sell, ON AVERAGE, in the range of 60% to 70% of revenue averaged over the past 3 to 5 years in metropolitan, non-costal locations, but the range varies widely and could exceed 100% on the East or West coast. Further, rural owners may not realize a sales price of even 50% of average revenue. So, in a city in the Midwest, a practice generating $800,000 annually may sell for $480,000 to $560,000 ($800,000 x .6 or .7). Practitioners will often use this “rule of thumb” to get an idea about practice value. Revenue multipliers are NOT actual valuation methods because, among other reasons, overhead and profit are ignored. We fully agree with Dr. Steve Wolff that revenue multipliers should only be used as a ballpark benchmark to gauge the overall reasonableness of a practice’s value.38
It should also be mentioned that another legitimate valuation method involves comparable sales of similar practices within a given geographic area. Importantly, most competent appraisers will utilize multiple methods and create an asking price based on a combination of methods. And bear in mind the last 2 or 3 years of practice financial data may be assigned a weighted value above the data from 4 or 5 years ago. Valuations are typically valid only for the very short term, perhaps 2-3 years at most.