I am asked no less than 10 times a week: "How is value arrived at?" The answer should be simple, but it is not. Several methods are acceptable and credible in determining a dental practice`s value. Some are quite involved and would require significantly more space than is available in this column. For those interested in a comprehensive understanding of valuation methods, I recommend "Valuing Small Businesses and Professional Practices," second edition by Shannon P. Pratt, published by Irwin Professional Publishing.
The following methods of valuation are the most commonly used and most easily understood.
Rules of thumb - Rules of thumb are generalizations of what has been happening in the market, as well as what might be expected to happen in the market. Rules of thumb do not take into account specific elements of the practice being valued, but they provide a broad brush stroke to the valuation process.
Because of the lack of specific comparisons, rules of thumb cannot assure an accurate value of a particular practice. The most important consideration in the use of a rule of thumb is the accuracy of the information relied on. Often I hear someone make the statement, "I understand that practices are selling for 70 percent of gross." Or, "I understand that practices are selling for one times net."
The question I ask is, "From where do you understand this information?" The only valid determination of an accurate rule of thumb is to evaluate enough actual market data to begin to see a legitimate trend. Obviously, the data must be germane to your practice if it is to apply. In other words, if yours is an oral surgery practice and you are applying data generated about a general dental practice, you are dealing in apples and oranges.
The market approach - Market approach simply compares your practice with other practices that have sold to determine the value of your practice. The theory behind this method is that a ready, willing and able buyer has paid a certain amount of money for a practice and the seller has sold for that amount of money, neither party being under any duress.
It is important that consideration of specific information be adjusted to reflect the differences in the practices being compared (for example, one practice has six operatories vs. a practice that has three; or a practice that generates $500,000 out of three operatories with one dentist vs a practice that generates $500,000 out of five operatories with two dentists). Other important considerations are capitation, the type of dentistry (C&B vs. restorative), equipment age and the demographics of the practice location. All of these issues need to be taken into consideration when comparing one practice to another in terms of value.
Capitalization of earnings - Capitalization of earnings is the process of converting a cash-flow stream (net income) to value. The process of capitalizing net income is somewhat complex, but is one of the most consistent and reproducible valuation processes. The majority of the calculations are objective with some limited subjective input. If the capitalization rate (cap rate) is properly determined, the value should be duplicateable by any qualified appraiser.
The philosophy behind using the capitalization of earnings method is to determine what return on investment could be expected if a third-party investor purchased the practice and hired (at market rates) a dentist to perform the dentistry. If the investor cannot make a reasonable return on his investment, it does not make any sense to make the investment. On the other hand, if he can get a reasonable return, then the price he pays for the practice is justifiable.
The process to determine value using capitalization of earnings requires adjusting the income and expense statement to reflect the actual operating expenses required to run the practice (including the dentist`s salary), identifying the debt service required to purchase the practice and determining the cap rate. Selecting the cap rate is determined by the market and is a reflection of economic and industry conditions such as interest rates, inflation and the outlook for the profession and the community.
The range of cap rates used to value dental practices varies from between 18 percent and 35 percent, the lower rate representing less risk and the higher rate representing greater risk. Most appraisers use their knowledge of the market, the demographics of the community and the information about the practice to select an appropriate cap rate. Selection of the cap rate is the most subjective process in this approach to determining value.
As you can see, the process of determining the value of a dental practice is much more complex than one might expect and the degree to which an appraiser uses one or more of the methods available usually is a function of the reason for the appraisal. If litigation, estate-planning or the sale of a practice requires an appraisal, it is important to select a qualified party who has the experience and market resources to provide a supportable valuation. If you`re just curious as to what your practice might be worth, use a rule of thumb - probably between 50 percent and 70 percent of gross (on a $300,000 gross revenue value between $150,000 and $210,000. For a swing of $60,000, it`s probably worth getting a legitimate appraisal).
Anyone can render an opinion, but a qualified opinion requires expertise that can only be gained through experience and education.
H.M. (Hy) Smith is president of Professional Transitions, Inc., located in Naples, Florida. He is a member of American Dental Sales. Professional Transitions, Inc., assists dentists in selling, buying or financing practices. He can be contacted at (941) 262-3077.