QUESTION: What appraisal methods are best for dental practices?
ANSWER FROM J. HADEN WERHAN, CPA/PFS:
Formal business appraisals include three approaches—income, asset, and market-based.
The income approach uses three methods to determine the value of a business based on the future economic benefit to be derived by a buyer. These are discounted cash flow, capitalization of earnings, and multiple of discretionary earnings. The asset approach includes two methods: asset accumulation and capitalization of excess earnings. The market approach uses comparable sales. Here I will look at discounted cash flow and capitalization of excess earnings.
Using the discounted cash flow method in the appraisal of a dental practice, the net cash flow is projected for a period of years and a desired rate of return is applied. 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 high fees and low overhead. Each year will have a different result and will impact the value of the practice to a particular buyer. Translation: An appraiser can help a dentist determine what they are willing to pay for a practice based on different assumptions.
Capitalization of excess earnings allocates the net practice cash flow over three factors: labor, tangible assets, and intangible assets. After allocating earnings to the measurable factors (labor and tangible assets), any remainder is excess earnings and forms the basis for goodwill value. In a dental practice, excess earnings are the profit after a surrogate dentist’s compensation for only performing dental procedures. Thus, excess earnings is attributable to an owner dentist and must be present for goodwill to exist. Those excess earnings are capitalized to calculate the value of goodwill. The total value of the practice is the sum of the tangible assets and the goodwill. This method will generally be used by forensic accountants when the value of a dental practice is needed by a third party or in a dispute, such as a divorce or partnership dissolution.
ANSWER FROM KYLE FRANCIS, MBA:
Discounted cash flow (DCF) and capitalized earnings are both effective, and both work in dentistry. However, these methods rely completely on assumptions that can dramatically skew the implied value of a practice.
In a discounted cash flow model, the goal is to figure out the present value of the investment (i.e., a dental practice). First, learn the future cash flow. Typically, our company uses adjusted earnings before interest, taxes, depreciation, and amortization (EBITDA) as the corollary to determine how much an investor will get once all the practice level expenses are paid. Then, we establish how long the dental practice is going to be owned and the rate that the EBITDA will grow with the new owner. Finally, we apply the rate that the new owner wants to realize over the term of that investment and discount each year’s growth-adjusted EBITDA by that rate of return. The price paid for the practice is the sum of the DCF over the years someone will own the practice.
Here is the thing: the growth rate, number of years, and rate of return are all chosen by the buyer, and this can lead to a fair amount of human error.
In a capitalized earnings approach, there is a similar process. Again, the best number to figure out is EBITDA as that is the investment value of the practice. The buyer can decide to add a growth rate to the future EBITDA to determine what the yearly cash flow of the dental practice will be. Next, a cap rate is applied to the practice. This is done by dividing the investment value of the practice per year (EBITDA) by the cap rate to figure out what should be paid. Unfortunately, this is still limited by the cap rate that is chosen.
Both methods are used to make sure someone is not overpaying for a practice; however, the fallacy often seen is allowing the chosen variables, rather than the market, to determine the value. Dental practices are most affected by the comparable practices that are sold in the area and the type of buyers that are buying them, whether an individual dentist or an institution.
Both of these methods work, and each can be a great tool in a valuation toolbox. But just like any tool, if they’re used incorrectly or for the wrong job, they can make everything more difficult.
J. HADEN WERHAN, CPA/PFS, has worked with dentists since 1980. He is a partner with Thomas Doll, a CPA, pension plan administration, and wealth management firm located in Walnut Creek, California, that serves more than 400 dentist clients. The firm is a member of the American Institute of Certified Public Accountants (AICPA), California Society of CPAs, and a founding member of the Academy of Dental CPAs (ADCPA).
KYLE FRANCIS, MBA, has worked in the dental and medical field since 2005 consulting for practices, medical device companies, and groups of practitioners. He has consulted over 50 startup companies and dental practices, as well as helped build more than 100 dental and medical practices. Francis created Professional Transition Strategies in 2007. He has facilitated the sale of over 350 dental practices and his mergers and acquisitions work has resulted in over $200M in total deal flow.