Is It Net or Gross?

A question I get all the time is “What should the value of a practice be as a percentage of gross?”  Not only is the answer immaterial, the question itself is irrelevant.  What you do need to know is that there are three fundamental economic components to any business.  The first component is revenue, the second component is cost, and the third component is profit.  The third component (profit) is a function of subtracting the second component (costs) from the first component (revenue).  As a business owner, the only component that is yours at the end of the day is the profit.  The only component that you can use to pay for your lifestyle which includes paying off your debts, is profit (and to be more specific, it’s profit after tax).

Over the course of a year I analyze dozens and dozens of practice financial statements, and over the years I have analyzed hundreds of practice financial statements.  I have yet to come across two that are exactly the same.  Dental practice costs, not including associate costs, usually range anywhere from 40% of gross to 70% of gross, and on occasion even outside of those parameters.  Associate costs can range anywhere from 20% to 30% of gross, depending on the type of dentistry being done, and the amount of gross revenue generated from hygiene fees.

The one metric that used to be somewhat consistent was the expected return on investment (ROI).  Up until recently that return was 20%.  If a practice was fairly valued the profit (before tax) would be about 20% of value of the practice.  A practice with a $200,000 profit would have been valued at around $1M.  Due to either an abundance of dentists or a relative lack of purchasable practices, the expected return on investment has been diminished.  Buyers anxious to acquire a practice have been prepared to accept a lower return on investment.  A 20% ROI equated to a practice value which is 5 times the net profit (100% / 20% = 5).  This is called the “Multiple” and it is the common metric that experienced buyers pay the most attention to.  While a 5 times Multiple equals a 20% return, a 6 times Multiple equals a 16,7% ROI.  Today most practices sell at a 5.5 times to 6.5 times multiple.  Anything above a 7 times multiple will not leave enough profit to pay taxes and loan payments.

So how does this equate to gross?  The answer is that it doesn’t.

Let’s assume three practices all grossing $1M, one with Net Profit of 20% of gross ($200,000), another with Net Profit of 25% ($250,000) and the last with a Net Profit of 30% ($300,000).  If you were going to base value as a percentage of gross – in this example 125% of gross – that would mean that you would be prepared to pay the same for each of the three practices, even though practice three returns a 50% greater return than practice one.  Consider the following:

Practice 1
Gross                                                                                    $1,000,000
Net Profit (20%)                                                                   $200,000
Value at 125% of Gross:                                                    $1,250,000
Value at a 5 times Net Profit:                                          $1,000,000

Practice 2
Gross                                                                                    $1,000,000
Net Profit (25%)                                                                    $250,000
Value at 125% of Gross:                                                    $1,250,000
Value at a 5 times Net Profit:                                          $1,250,000

Practice 3
Gross                                                                                    $1,000,000
Net Profit (30%)                                                                   $300,000
Value at 125% of Gross:                                                    $1,250,000
Value at a 5 times Net Profit:                                          $1,500,000

This should tell you a couple of things:

  1. If Gross Revenue was the value determining factor, and if Practice 2 was determined to be a fair trade, then the purchaser of Practice 1 would have paid too much and the vendor of Practice 3 would not have been paid enough. All other things being equal, any three investments that return $200,000, $250,000 and $300,000 should not be worth the same amount.
  2. All other things being equal, Net Profit, not to be confused with Gross Revenue, should be the number that you use to determine the value of virtually any dental practice. Value needs to be a function of your return on your investment.  In the case of a dental practice, Net Profit is your return and is the metric which should dictate value, not Gross Revenue.
  3. Now here is the important point – if you have an accountant or other advisor that is telling you that the value of you practice is a function of Gross Revenues, then seriously, you need a new accountant or advisor. If they do not understand this very basic economic principal, then what other basic business and tax principals or concepts are they getting incorrect?

I have seen too many dentists suffer major negative consequences from thinking about value as a function of Gross.  Anyone who tries to tell you that the value of either your practice, or a practice that you want to buy, should be “some percentage” of gross, is giving you very bad information and you should look elsewhere for your advice.

If you would like to discuss this blog or any other of my blogs, please contact me directly at 905-984-5816 or at dhill@hillkindy.com.