How Multiples are Determined
My business is brokering dental practices. My objective is to help my clients maximize the return on their practice investment when they do sell. My blog posts are all about sharing skills and strategies that will ultimately maximize your cash flow and practice value – enjoy.
Whether you are a single dentist, an “investor” dentist, or a corporation, the purchase of a dental office is an investment. Every investment should produce some financial return, and different types of businesses have different returns, usually related to the risk of actually getting a return. For example, a Government of Canada bond will have a lower interest rate than a corporate bond. The reason for this is that there is virtually no risk with an investment in the Country of Canada, whereas an investment in a corporation is much riskier. The following chart sets out typical rates of return for various investments.
As you can see, the rate of return increases as the risk increases. Imagine you were going to invest in a new toy called a hula hoop, not knowing if the hula hoop craze would last longer than a couple of months; an astute investor would want a very high rate and a quick rate of return.
If you owned a $1,000,000 Government of Canada Bond at 2.23%, you would receive an annual interest income of $22,300. If you owned a dental practice that was worth $1,000,000, you should expect to receive an annual income of between $140,000 and $180,000. This would not include any percentage you might earn as an associate or professional income.
Multiples are the inverse of a rate of return. A Rate of Return of 20% means that you will earn 20% of the value of your investment as income. If you know your income and divide that amount by your rate of return, you can figure out the value of your investment. We can apply the same principle to estimating the value of a dental practice. If we know the rate of return for a dental office, we’ll assume 16%, and we know the annual net income, we can calculate the estimated value. Assume our net income (profit) is $150,000 and our expected rate of return is 16%; we can divide the $150,000 by 16% to get an estimated value of $937,500. As it turns out, people would rather multiply than divide. So instead of dividing the net profit by the rate of return, people started multiplying the net profit by the inverse of the rate of return, which we know as the Multiple. For example, the inverse of 16% is 6.25; therefore, using a slightly different formula, $150,000 X 6.25 gives us the same $937,500.
The very difficult question is where did the Return on Investment percentage come from and that is a very complex question that is largely beyond the scope of this short blog post. The simple answer is that Return on Investment rates for different industry types (retailers, manufacturers, service providers, and dental professionals) have developed over years and are a combination of supply and demand, risk assessment, and other investment opportunities. If you really need to know the answer to that question, ask Google – I did and got 207,000,000 responses in .64 seconds.
Closing Thoughts: After working exclusively with dentists for the last 40 years I know that every practice has some upside potential and in many cases lots of upside potential. In order to make the most of your investment it really helps if you understand the factors that go into setting the price you pay for a practice. The price you pay will be determined by a number of factors, including the current Return on Investment rate for dental practices. Make sure any appraisals that you consider are based on cash flows and current Return on Investment rates. Check back often because there will always be something of value here whether you are selling or not.
Written By: Derek Hill, CPA., CA., Broker of Record