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Dental practice appraisals and COVID-19

Sept. 1, 2020
J. Haden Werhan, CPA/PFS, breaks down different approaches to dental practice appraisals and how COVID-19 will affect valuations.

In the world of formal business appraisals, there are three approaches: the income approach, the asset approach, and the market approach.

The income approach

This approach uses three methods to determine the value of a business based on the future economic benefit to be derived by a buyer: discounted cash flow, capitalization of earnings, and multiple of discretionary earnings. The latter two methods apply discount rates and factors to the cash flow to arrive at a value. The discount rates and factors used (location, management, competition, financing, etc.) are subjective and based on the opinion of the appraiser.

The discounted cash flow method establishes the value of a business based on the future economic benefit to be derived. For a dental practice, this is done by projecting the income, expenses, and net cash flow for a period of years and applying an appropriate discount rate or desired rate of return. Ten years is common, and the starting point is the current information for the dental practice being assessed. The underlying concept is the time value of money—that a dollar invested today will be worth more or less at some point in the future. The benefit of this method is that one may change the inputs from year to year to arrive at different outcomes. For example, if a buyer plans to convert an insurance-based practice to cash, those assumptions can be built into the model. This will mean lower profit initially and, hopefully, increased cash flow later from higher fees and lower overhead. Each year will have a different result and impact the value of the practice to a given buyer. Translation: the purchasing dentist can figure out what they are willing to pay based on what they expect to happen in the future.

The asset approach 

This approach includes two methods: asset accumulation and capitalization of excess earnings. The asset accumulation method applies various calculations to the balance sheet of a business to determine the value of tangible assets and intangibles such as goodwill. 

The capitalization of excess earnings method allocates the available cash flow of a business over three factors: labor, tangible assets, and intangible assets. After allocating earnings to the measurable factors (labor and tangible assets), the remainder is excess earnings and forms the basis for goodwill value. 

In a dental practice, excess earnings represent the profit of a practice above the profit that might exist if a salaried, nonowner dentist was providing patient care. Excess earnings are attributable to the owner-dentist and must be present for goodwill to exist. In the final analysis, excess earnings are capitalized to calculate the value of goodwill. The value of tangible assets may be determined by a separate appraisal or by a calculation known as “economic depreciation,” which is different from tax depreciation. For example, if an x-ray unit was purchased 2 years ago for $5,000 and has an economic life of 10 years (versus 5 years for tax), its economic value is $4,000 ($5,000 ÷ 10 years = $500 x 8 years (10 - 2) = $4,000). This calculation must be done for all of the assets in the practice to determine their value.

In summary, the value of the practice is the sum of the tangible assets and goodwill. It is generally assumed that accounts receivable and any other assets of the practice are either retained by the selling dentist or given a separate value and purchased by the buying dentist. 

The market approach 

This approach uses historic sales of similar businesses, or “comps,” to establish the value of a particular business. Since there is no Zillow for dental practices, an appraiser must find data from other sources. They may have a network of practice brokers or use The Goodwill Registry—a database of dental practice transactions maintained by The Health Care Group located in Pennsylvania.

Factors to consider

COVID-19 has created a new normal for dentistry filled with uncertainty and questions about future practice closures, practice viability, employee retention, increased operating and capital costs, and reduced patient flow. How does a dental practice appraiser account for the new normal? Do bailouts from the federal government impact appraisals? A well-funded dental practice is more viable, but increased debt from Small Business Administration programs such as Economic Injury Disaster loans and Paycheck Protection Program loans—not all of which will be forgiven—impact the future cash flow of a practice as do the significantly increased costs of personal protective equipment and other infection control measures.

An appraiser should incorporate these and other factors into any appraisal approach being used. In the discounted cash flow method, the appraiser must start with current year numbers and exercise professional judgment when adjusting them going forward. They may adjust discount rates applied to the cash flow and increase the period of years used to mitigate the impact of 2020 on practice incomes.

The capitalization of excess earnings method will also require adjustments to account for the impact of COVID-19. Uncertainty will drive discount rates up, thereby lowering goodwill value. If a practice has excess earnings of $150,000, a discount rate of 20% renders a goodwill value of $750,000 ($150,000 ÷ 20%). If the discount rate is increased to 22%, the goodwill value is $682,000—a difference of $68,000.

In other methods under the income approach, the cash flow or adjusted earnings of the practice being appraised undergo various calculations before being capitalized. Often, the earnings from a period of years are looked at to capture fluctuations. Typically, the most current year will be given more weight than prior years to more accurately represent the current circumstances in the value of the practice. Conversely, if the most current year is very different from prior years, the appraiser may give it less weight. 

To illustrate weighting, let us assume the numbers in Table 1 for the three years ending December 31, 2019. 

To arrive at the weighted average income, 2019 is added three times, 2018 two times, and 2017 one time [(155,000 x 3) + (149,000 x 2) + (139,000 x 1) ÷ 6 = $150,000]. An appraiser may want to study more years or increase the weighting assigned to any given year.

If we assume the results in Table 2 for the three years ended
December 31, 2020, the weighted average income is $13,000 lower than a year ago (150,000 – 137,000 = 13,000). Capitalized at 20%, that is a $65,000 reduction in value. What a difference a year makes! Finally, in Table 3, assume the same numbers as Table 2, but adjust
the weighting to 1, 3, 2 with 2019 given more weight than 2020 and 2018. This increases the weighted average income $10,000 because 2020 is only added into the equation one time.

If that difference of $10,000 is capitalized at 20%, the result is an increase in value of $50,000. This is a simplistic example to illustrate that a small difference in the math can have a significant impact on the appraised value of a dental practice. The professional appraiser must decide which approaches and methods to use, how to weight any numbers being studied, and then determine appropriate capitalization rates to use given numerous variables.

Advice for practice owners

I would advise a dentist who is having or has had their practice appraised to ask the appraiser about the numbers used in any calculations to confirm their accuracy. They should also ask about the subjective decisions made throughout the appraisal process so they understand how the final value was determined and whether it seems reasonable. Finally, a proper appraisal report will include a letter summarizing the approaches and methods used, their appropriateness for the particular assignment, a summary of the practice information used (financial statements, tax returns, day sheets, general ledgers, premise leases, etc.), historical information about the practice, the state of the dental industry (a real test of the appraiser’s knowledge of dentistry), the economy in general, and the appraiser’s credentials. The appraisal report will also include all the calculations made, all the documents supporting those calculations, and any appropriate notes or references. 

Remember: you obtained an appraisal for a reason, and you want it to contain all of the information necessary for a reader to understand and assess it for its intended purpose.  

J. Haden Werhan, CPA/PFS, has been working with dentists for 40 years. He is a partner at Thomas Doll in Walnut Creek, California—a CPA, retirement plan administration, and wealth management firm with over 600 dentist clients. Werhan is a member of the American Institute of Certified Public Accountants, California Society of CPAs, the Academy of Dental CPAs, and 30 CPA firms across the country representing more than 9,000 dentists.