buy or sell a dental practice in Ontario, dental practice brokerage, practice appraisals, business valuation, negotiating sales

What to Look for in a Good Appraisal

Whether you are a buyer or a seller, you are going to be dealing with appraisals.  As a seller, you want your appraisal to justly represent the value of your practice; if it doesn’t, buyers will become suspect and immediately dismiss the idea of a purchase.  As a buyer, you need to be able to determine whether or not the appraisal you are reviewing fairly represents the true value of the practice which is under your consideration.  Whatever the case may be, there are certain components which should always be found in a well-executed appraisal.  In this blog we are going to address some of the more essential components to look for in a high-quality appraisal:

  1. Valuation Methodology
  2. Cash Flow Analysis
  3. Return on Invested Capital
  4. Financial Upside Potential and Downside Risks

 

  1. Valuation Methodology

The appraised value of a dental practice should be a function of normalized cash flow and the risk inherent in maintaining that cash flow over a period of time – usually 5 years.  Normalized cash flow is basically the true operational net profit of the practice after it has been adjusted to remove non-operational costs such as family salaries, travel costs & the personal portions of promotional costs, but includes a provision for professional compensation.  Professional Compensation is the amount that an owner would have to pay an associate(s) if all of the dental revenue was produced by same.  Risk is a factor that primarily represents the likelihood of being able to maintain the current normalized earnings over, typically, a 5 year period.

VALUE ≈ PROFIT & RISK

You will find differing valuation methods being used amongst appraisers, however, some tend to be very subjective in nature, and are often inconsistent or contradictory from one appraisal to the next.  For example, a commonly used valuation method is to compare one practice where the value is known, as evidenced by a recent sale, to the practice being appraised.  This is a methodology that can work well in real estate where the differences between one house and another can be easily identified.  Dental practices however, are much more complex and do not lend themselves well to such comparisons.  Accordingly, appraisals based on this type of methodology can be misleading and should be thoroughly reviewed with your dental accountant.

 

  1. Cash Flow Analysis

A fundamental aspect of the risk factor noted above is the likelihood of being able to maintain profitability over a period of time.  In order to properly determine this probability it is necessary to be able to forecast the expected cash flow using some defensible criteria for that preparation.  It is not sufficient to just present a subjectively prepared and unsubstantiated cash flow.  An appraiser should set out and be able to support the criteria used for projecting any future cash flows used in the appraisal.

 

  1. Return on Invested Capital

Every capital investment is made with the expectation of some return on invested capital.  Each business type has a different expectation of return.  The riskier the business type, the higher the anticipated return.  Currently, the expected return for a dental practice in Ontario is 20% before acquisition interest, taxes and depreciation.  For example, a practice appraised at $2M should have net earnings before interest, taxes, depreciation and amortization (EBITDA) of $400,000 – this is after paying all dentists that work in the practice, including owners, as if they were associates.  A good appraisal should be able to equate, explain and support the appraised value in terms of its relationship to the anticipated EBITDA.

 

  1. Financial Upside Potential and Downside Risk

A subset of the risk factor is the determination of the potential for a practice to grow, or increase its revenues, at a greater than historical rate.  Conversely, it can tell you if there is a risk that a practice will not grow at historical rates, or possibly experience a decline from historical revenue levels.  A practice generating much lower than average levels of hygiene revenue would represent a practice that would probably have good financial upside potential, assuming the reasons for the lower than average hygiene billings were remedied.  On the other hand, a practice with a very elderly patient base and low new patient inflow will probably have an increased risk of maintaining current revenue levels due to a reduction in the size of the active patient base.  If an appraisal is to be truly useful to a buyer, or a seller, it must clearly set out both the Upside Potential and the Downside Risk inherent in the financial future of the practice.

 

There are certainly more key elements that can be found in a good appraisal – too many to be included in this blog.  If, however, the components noted above are not found in an appraisal, then it may not fairly represent the true value of the practice in question.  If this is the case, you should be discussing the appraisal in greater depth with your dental accountant to make sure that you can pay for what you buy.