When buying or selling a dental practice, one of the most fundamental processes of the deal is how to value it.
The fact of the matter is, most dentists don’t know the current value of their practice. And when it comes to accurately appraising the value of an office, fewer dentists understand how accountants, brokers, and buyers define their dental practice valuation methods.
Dental practice valuation is a confusing subject in which there is no single standardized methodology. And yet, it’s one of the most important. Buying or selling a dental office may be the biggest decision of your professional career. You don’t want to get shortchanged or leave money on the table in the process. With your financial-wellbeing at stake, it’s vital that you understand which dental practice valuation method best suits your office and your market.
How to Value a Dental Practice for Sale: 3 Valuation Methods
Determining the value of a dental practice is often subject to misconceptions and differences of opinion. Some dentists believe their practice is worth an average of 70% to 80% of their last three year’s collections. Others think it’s a simple multiple of 1.5 times their net income. To best understand how to value a practice, below are three dental practice valuation methods that are commonly used today.
Net Asset Valuation Method
The net asset method is based on an appraisal of all tangible assets (real estate, equipment, technology, computers, office furniture, etc.) and intangible assets (practice goodwill, trademarks, patents, etc.). Most practices have the majority of their value in intangible assets. In fact, a widely embraced “rule of thumb” for dental practice valuation is that 80% to 85% of a practice’s value comes from goodwill.
The disadvantage of the net asset valuation method is that it’s often a vague and unreliable measurement of the true value of the practice. Not only is it ambiguous and difficult to accurately appraise practice goodwill, but this method can undervalue much older dental practices that may have older systems or technology. For this reason, net asset methods should be used mainly as a point of reference next to other valuation methods, or under special circumstances in which a practice is financially compromised or has significant real estate holdings.
Market-Based Valuation Method
This method takes into account the historical collections of the practice multiplied by a collection’s multiplier (which often ranges between 60% and 80%) – all while factoring in local market data of other dental practice sales in your area. This valuation method also has its drawbacks, as it’s based solely on collections and fails to account for profits. Making matters worse, acquiring comparable practice sales figures in a local area can pose limitations with the market-based method. If a practice is not based in a metropolitan area with several relevant data available, it can be difficult to compare apples to apples with the market-based valuation methods.
Income-based Practice Valuation Method
It’s important to note that the value of any business is largely based on its cash flow, the risk of investment, and the return on investment for the buyer. This is why the most knowledgeable buyers and sellers commonly use the income-based method to effectively calculate how much a practice is worth. This approach, which is determined based on capitalized earnings or discounted cash flows, offers a sound solution to accurately establish the fair market value of most dental offices.
When using income-based valuation methods, “income” is simply defined as the pre-tax cash flow of a practice. Here’s how each method works:
Capitalized Earnings Method — This is the most popular income-based valuation method. It takes the prior year’s net income (or the average of the last few years income) divided by a capitalization rate to determine the fair market value of a dental practice. The industry standard cap rate ranges anywhere between 15% to 30%, but closer to 25% to 31% on average.
Discounted Cash Flows Method — This valuation method forecasts the practice’s net income for the next 10 years and calculates the net present value of that total income. The projected cash flows are based on a projected growth rate of collections and expenses each year, and then discounted by the assumed cost of capital plus a risk premium. This ranges from 23% to 31%.
Final Thoughts About Dental Practice Appraisal
There’s no question that every dental practice is a unique entity with a plethora of differentiating factors that must be taken into account. In addition to analyzing the expenses and collections side of a practice’s financials, there are many other factors that must also be considered. Some of these factors include the location, staff, reputation, longevity, equipment, procedures offered, and patient mix.
Weighing how much impact each factor has on a practice’s value is more of an art than it is a science. This underscores the importance of having a knowledgeable and experienced transition consultant to help facilitate the dental practice valuation process. The more you know going into the sale of a practice, the better off you’ll be both financially and personally.