For dental professionals looking to sell their practice, one of the most frequently asked questions our advisors receive is “What is my practice worth?” In search of rules of thumb or profit multipliers, the truth, unfortunately, is not as simple as most would hope.
Before you can understand how much your practice is worth, you first need to understand how your practice’s value is determined. This can be done a few different ways, the most common is through a formal valuation, which includes a financial and written analysis of the practice.
“The value of a practice is determined by analyzing two primary drivers: risk and profitability,” said NDP’s certified valuation analyst Dawn Whitehurst. “It is based off historical data, what the practice has shown to produce or collect and what risk level it presents compared to other dental practices.”
What is a Valuation?
A valuation is a process that assesses the dental practice’s current and historical financial position as well as its operational results. The valuation leverages both tangible and intangible factors to show a buyer what to reasonably expect from future performance and provides information on a company’s risk profile.
The following factors are typically taken into consideration for a valuation:
- Nature of the business and recent history
- Economic outlook of the practice and the industry
- Financial condition
- Earnings capacity
- Goodwill or other intangible value that exists within the practice
Dental practice valuations are unique in that they typically must consider a minimum of three full years of historical financials and profitability. This is because dental practices and the dental industry can experience seasonality. Practices can be impacted by changes to the national and local economy, dental insurance and patient’s acceptance of proposed treatment, among many other factors. The COVID-19 pandemic, for instance, significantly impacted most businesses, including dental practices, making multiple years of financial history particularly helpful in this situation.
At NDP, our valuation analysts typically review four years of financials to have enough data for identifying trends of the practice. The history can show where there has been growth, decline, or stability in the practice.
Types of Valuation Approaches
There are three commonly accepted approaches: the asset approach, market approach, and income approach. The type of approach chosen for a valuation is determined after looking at the characteristics of the business, the purpose of the valuation report, the pattern of historical performance and other considerations.
The asset approach identifies all the business’ assets (both tangible and intangible) and liabilities. A company’s assets may include equipment, inventory or credited amounts owed to the business.
This approach is typically used for holding companies or asset-intensive operating companies, such as a company that produces staplers or binder clips. It is not a common approach for dental practices because they are a service-based business. Additionally, the asset approach is driven by the value in the equipment rather than the skill and expertise of those using the assets.
Although dental practices can have considerable investments in tangible assets, a buyer and seller are likely to focus more on the cash flow and earnings potential as opposed to the value of the standalone assets.
The market approach estimates the company’s value by comparing pricing and revenue indicators among similar companies. In attempt to use the value of one company to estimate another, this approach looks at business and operational characteristics, growth patterns, relative size, earnings trends, markets served and risk characteristics.
In markets where there is a plethora of available data, such as residential real estate, the market approach can easily be applied. However, the market approach is not used often for private businesses, such as dental practices because the data behind the sale and value of most privately owned businesses isn’t published to the public. Not having this information makes using this approach challenging.
“In the valuation world, the market approach is the most accurate method of valuation, if the data exists,” Dawn said. “Unfortunately, in our opinion, the data pool we often have for dental practice sales is too small to statistically feel comfortable using this method.”
The income approach is the method most often used for valuing a professional service company, such as a dental practice. This method takes into consideration the amount of cash flows the company produces for the owner while applying a risk rate. It also considers all tangible and intangible assets.
The income approach generally utilizes one of two methods: discounted cash flow (DCF) or capitalization of earnings.
The DCF method is based on the theory that the value of a business is the value of its anticipated future cash flows. This method uses projections for future financial performance—how much money it will generate in the future—over a specified period of time which is generally three to eight years.
After making estimates about future cash flows as well as the ending value of equipment and other assets, a discount rate is applied to these projected earnings. This discount rate incorporates an appropriate safe rate of return, adjusted to reflect the business’s perceived level of risk. The DCF method is typically used when there are reliable long-term projections available, something most dentists do not prepare, making this method unreliable in dental practice valuations.
The American Dental Association (ADA) notes that the capitalization of earnings method, also referred to as the capitalized income method, is often the most recommended method and is heavily utilized by most dental appraisers.
The capitalization of earnings method reviews the historical cash flows and applies a risk rate to determine an expected value for the business. A dental practice’s history is the most likely predictor of future success since it shows what the practice can produce. The value is based not on potential, but rather on what has happened in the past.
Consideration of Goodwill
Not only do valuations look at tangible assets like cash and equipment, but they also consider intangible assets. A specific type of intangible asset that valuations should account for is goodwill, which is a miscellaneous category of assets that is more difficult to measure directly.
Goodwill is defined as an intangible asset consisting of the excess earning power of a business. Generally, the higher the excess earnings, the higher the allocation of the purchase price will be to the intangible assets of the practice.
In a dental practice valuation, goodwill can encompass the providers reputation, an established practice name, the practice website, social media accounts, phone numbers, marketing materials, location, excellence of management, a reputation for general or specialized services, established practice processes and an ongoing working relationship between the patients, doctors and staff.
Ultimately, these factors can help mitigate the risk in a transition and often result in greater profitability. In essence, goodwill is what makes a practice worth more than the sum of its parts.
Impact of Adversity on Valuations
Like most businesses, dental practices experienced the adversity of the COVID-19 pandemic. Difficult times have the ability to change perspective, and one rogue year may not be an honest indicator of the future. Therefore, it’s important to remember that valuations involve reviewing at least three years of financial history. In the case of COVID-19, where most businesses temporarily shut their doors, the valuation would look at how the practice performed before and after the closure. This prevents the valuation from over or underestimating the impact, and it prevents the practice from being penalized for something that was out of its control.
Need a Dental Practice Valuation?
NDP is dedicated to providing thorough, reliable dental practice valuations to help an owner understand what their practice is worth. For Dawn, who has a lengthy history of firsthand experience in the dental field working in oral surgery, she brings a well-rounded view of the business to each valuation.
“It gives me a sense of pride to lead the valuation side of our business knowing I have in-depth knowledge of the industry,” Dawn said. “This hopefully imparts trust and confidence in our clients.”
We realize how critical an accurate and honest valuation is in transition, so reach out to a member of our team to get your valuation questions answered.