Understand how EBITDA relates to your practice’s value
If you’re looking to buy or sell a dental practice, you likely have seen the term, EBITDA, in your research or conversations. The term is commonly used in the dental transition world, but what exactly does EBITDA mean? How does it work and what role does it play in determining a practice’s value?
An accounting term, EBITDA stands for Earnings Before Interest, Taxes, Depreciation and Amortization, and specifically for dental practices, it is a measure of the expected cash flow. It’s the net profit of a business after normalizing expenses and owner’s pay. While general accounting differentiates EBITDA and cash flow as separate metrics, the two terms are sometimes used interchangeably given the cash-basis accounting used for specific types of companies, such as dental practices.
When it comes to practice value, a common misconception is that the value is based solely on a percentage of collections. While this number can function as a guideline, it is merely a starting point. Another misconception is that the EBITDA is the value of the practice, yet it is only one part of the story.
The Full Picture
When looking at the full picture, EBITDA plays an integral role in dental practice valuations. Valuations involve assessing the practice’s current and historical financial position. Among the various valuation methods, the most common approach in the dental world is the income approach, which takes into consideration two elements that work together: profitability and risk.
EBITDA is the most common metric that determines profitability. Profitability is not just what the tax return shows but the net income with discretionary expenses added back. These discretionary expenses are business or personal items that are not necessary for continuing operations. A few examples of these expenses include continuing education, dues and subscriptions, travel and meals, personal taxes and auto expenses.
The other element, risk, consists of “good” or “bad” factors that differentiate one practice from another. These factors may include the type of practice, location, patients, competition and equipment. Some of these factors have little impact on the overall practice value, while other factors have a larger impact.
Together, profitability and risk can establish the true value of a dental practice.
EBITDA Calculation Example
Let’s see how EBITDA works in an example. The numbers below are for a general practice with collections of $1,400,000.
|Net Income (per tax return)||$50,000|
|Clinical Education (CE)||$10,000|
When we take the net income of $50,000 and add the discretionary expenses, we get an EBITDA of $520,000.
There is one caveat, however, to this number. $520,000 illustrates the EBITDA before doctor compensation, and we also want to be mindful of the EBITDA after doctor compensation.
Two Levels of EBITDA: Before and After Doctor Compensation
When calculating the value of a practice, there are two levels of EBITDA:
- EBITDA before doctor compensation (pre-EBITDA)
- EBITDA after doctor compensation (post-EBITDA)
Simply put, pre-EBITDA is the profit of the practice before paying the doctor to do the work, whereas post-EBITDA is the profit of the practice after paying the doctor to do the work.
When a buyer is purchasing a practice as an investment—as in dental service organizations (DSO) or private equity (PE)—the profit they care about is what is left after doctor compensation. Understanding this difference will prevent a false idealization of what potential value may exist.
Let’s use the same numbers from the example above to calculate the EBITDA after the doctor is paid. Given that the doctor’s collections are $1,100,000, here is how a PE firm will generally calculate the EBITDA:
The net benefit of $520,000 (the pre-EBITDA amount) is the baseline and is then reduced by what the firm would pay the doctor to work back in the office following the sale. We calculate this reduction amount by taking the doctor’s collections of $1,100,000 and multiply it by a compensation rate of 27% of collections to get an amount of $297,000.
Note that this compensation rate can range from 27-35% depending on practice and specialty. It’s important to understand that the higher the compensation rate, the lower the post-EBITDA and ultimately, the lower the practice value.
Finally, we would subtract $297,000 from the $520,000 net benefit, resulting in a $223,000 post-EBITDA.
$1,100,000 (doctor’s collections) x 27% (of collections) = $297,000
$520,000 (net benefit / pre-EBITDA) – $297,000 = $223,000 (post-EBITDA)
The PE firm would then multiply the post-EBITDA by a multiplier number to arrive at the price they are willing to pay. Multipliers are applied to the calculated post-EBITDA when determining the price of the practice. They reflect the market’s perception of a practice’s value and can range based on unique aspects of the practice, such as market, location and overhead. Multipliers can also change over time.
The Key Takeaway
For dental practices, EBITDA is used to determine the profitability. It’s important to note that EBITDA is only one piece of the practice’s valuation, and it’s not meant to be the sole measure of the practice’s value. EBITDA can indicate a lot about a practice’s financial performance, but it often only tells part of the practice’s story. And at the end of the day, a dental practice is more than just a number on a piece of paper.
Our advisors guide clients to expand their view and thoroughly look at all sides of a practice, so they can make the most informed decision possible when buying or selling a dental practice. Confidence comes with transparency. Contact a member of our team today.