Posted on Apr 9, 2012
Image Credit: © Dreamstime.com
Posted on Apr 9, 2012
By Randon Jensen, Larry M. Chatterly and Susannah Hazelrigg, CTC Associates
Over the years, many formulas for determining the value of a dental practice put forth. Some valuation reports are so elementary they leave the reader wondering if the value was chosen by rolling dice and adding zeros; others are so complicated a Masters Degree in mathematics would be required to understand them.
The value of any professional practice is largely based on its capacity to generate cash flow. That capacity is made of two essential elements: intangible and tangible assets. Intangible assets include goodwill, relationships developed with patients and referral sources, as well as the relationships between the selling doctor and staff. Tangible assets consist of clinical equipment, office equipment, furniture, fixtures, instruments, supplies and so forth.
The combination of these assets provides a “going concern” that possesses value as best demonstrated by its track record of generating cash flow and profit. How the cash flow and resulting profits are generated, and in what amounts, determines, in part, the price a practice may command in the marketplace.
There are three main approaches used to value professional practices: Income-Based, Market-Based and Asset-Based, and each approach has several different methods. In this article, however, we will discuss market-based and income-based approaches since the asset-based approach is primarily used to value practices with limited earnings history (e.g., newly started practices) or practices for which no significant value can be substantiated using one of the other two approaches.
An income-based approach is the widely used due to its ability to accurately assign a value to the cash flow of the practice. This approach is not limited simply to an analysis of historical financial information, however. It also requires analyzing recent, relevant practice statistics, characteristics and elements including: type, age, amount and condition of clinical and office equipment and furniture; accounts receivable outstanding; office fee schedule; supplies on hand; practice systems and management; patient profile and demographics; active patient count; new patient flow; participation in discount insurance plans; practice location; office lease status; practice type and philosophy; production by procedure type; status and history of staff and/or associates in the practice; tenant finishing in the office; and market and economic factors affecting the practice.
One distinct advantage of an income-based approach is its ability to determine a fair market value that will provide the buyer the ability to pay down the acquisition debt in a reasonable period of time while drawing a reasonable salary. It also accounts for a reasonable rate of investment return to the buyer in relation to the risk incurred.
As general rule, a dental practice will usually sell for 125% to 175% of its average, adjusted net income. Adjusted net income is the income after operating overhead, exclusive of any income taxes, interest, depreciation, amortization, capital acquisitions and compensation paid to the owner (such as a salary, benefits, retirement plans, personal insurance and profit sharing).
For example, assume a practice averages gross collected revenues of $800,000 per year and an adjusted net income of about $336,000 per year. Using the rule of 150% of adjusted net income, the estimated value of this practice would be $504,000.00 ($336,000 X 1.5 = $504,000). Simple enough. Simple formulas, however, like the one outlined above, do not take into account any of the practice characteristics discussed above that affect practice value. Those characteristics could and should be factored in when determining the appropriate multiplying factor.
Most dental practice appraisers will use more comprehensive and complex valuation formulas, such as the capitalization of earnings method, rather than a simple multiplier of net revenue due to their ability to more accurately account for such practice characteristics.