We feel that the article by Drs. Tanzi published in the October 2006 issue of DE® (page 116) does a great disservice to your magazine, dentists, and to those who are licensed, qualified valuation experts. Not only does the terminology alienate most readers (and we’re finance guys!), the information provided is fundamentally flawed both in methodology and in underlying risk assumptions, and will likely lead selling dentists to conclude their practices should sell at much higher prices than they should.
My colleagues and I have noted more than five technical flaws in their analysis, but the most important relates to their treatment of risk. In a DCF approach, the rate at which cash flows are discounted to present value is critical to the analysis. It measures the riskiness of the cash flows being measured. The implied rate they used in their calculation is around 10 percent. They indicate that dental practices are not inherently risky and should be compared to large companies. This is absurd. Certainly in a practice where things are going well, the risk might not seem inherent, but compare the effects of illness, death, or disability on a dental practice relative to a large corporation. Have you ever seen the value of a practice drop because the owner dentist dies suddenly? There are numerous risks that must be incorporated into an appropriate rate. The Tanzi article does not do this justice. Incidentally, typical service businesses such as law firms, accounting firms, medical and dental practices, etc., typically require a discount rate in the 20 to 35 percent range.
Additional material flaws in the article include:
Inappropriate treatment of debt in practice valuation. The authors remove debt expense from the cash flows of the practice to determine value. The capital structure (debt vs. equity) of a dental practice should not affect the value of the practice. Debt should merely be subtracted from the total value to reach an equity value.The analysis does not incorporate the consequences of paying taxes on the excess cash flow one earns by being an owner. A tax adjustment is required.Standard valuation practice uses a five- to seven-year projection period, not a 20-year period. At the end of the five- to seven-year period, the business is assumed to be sold.By making adjustments to correct for these errors and applying a reasonable discount rate, we conclude a practice value closer to the $500,000 range, in line with typical valuation ratios for dental practices - 63 percent of revenue. This is a material difference from the $1.07 million valuation concluded in the article. Buyers beware!Thank you for your attention to this. We enjoy reading your magazine and look forward to reading great articles in the future.Samuel Renwick, CFA
The Acumen GroupJeffrey Suchocki, CFA
Sinaiko Healthcare ConsultingRebuttal from Drs. TanziRenwick and Suchocki put forth several points of disagreement with our recent article and we appreciate the opportunity to respond. The issues raised are not as black and white as Renwick and Suchocki appear to believe; obviously, the specifics of the dental practice undergoing valuation will drive the assumptions used in a DCF analysis.We will respond to each of their four (they claim five, but we count only four) issues.Point 1: Renwick and Suchocki state that we have inappropriately considered the treatment of debt in practice valuation. They are incorrect. Assuming the buyer assumes the seller’s debt, discounted cash flow methodology should consider all relevant cash flows, including debt service. Service of debt principal and interest are projected negative future cash flows and we appropriately considered these cash flows in our example.Point 2: The authors point out that a DCF analysis should include the consequences of paying taxes on the excess cash flow that one earns by being an owner. On this point we agree; in a comprehensive valuation analysis, taxes should be considered.Point 3: Renwick and Suchocki state that “standard valuation practice uses a five- to seven-year projection period, not a 20-year period. We adamantly disagree. There is absolutely no standard in finance for such a short time period. Indeed, such a standard would be completely unrealistic - dental practices are typically held for much longer than five to seven years. Consideration of such an unrealistically short time period would not provide an accurate projection of business value.Point 4 (in paragraph after their bullet list): Finally and most important, the authors critique our assessment of dental practice risk. Renwick and Suchocki rightly point out that risk, and the corresponding discount rate applied to a DCF-based valuation, has a significant impact on calculated value. It is important to understand that there is no consensus in financial circles on the “appropriate” discount rate for a private enterprise such as an independently owned dental practice. This is an area that requires the judgment of the appraiser. Dental practice consultants do frequently use a discount rate of between 20 and 35 percent. However, we believe these rates are excessive, given the risk profile of most dental offices, and would lead to unjustly low valuations. Twenty to 35 percent discount rates mirror those applied by venture capital firms to high-technology startups - the majority of which are expected to fail! As Renwick and Suchocki state, dental practices have some additional risk of losing key employees (i.e., the dentists) compared to larger companies. Nevertheless, the revenue stream of a dental practice is more stable than most businesses. As such, we believe a discount rate of between 12 and 15 percent (similar to higher-risk public industries) is appropriate for a stable, established dental practice.Renwick and Suchocki end their critique by stating, “Buyers Beware!” We would modify this statement to read, “Sellers Beware!” We strongly believe that a conflict of interest exists with transition consultants providing valuation services. Similar to real estate agents, the primary motivation of the transition consultant is to close a deal. This provides an incentive to undervalue a practice - at the expense of the seller - to facilitate the transaction.Giancarlo Tanzi, PhD, and Jill A. Tanzi, DDS
