The Value Equation
Very simply, value is a function of profitability. Professional valuations, particularly as they relate to the valuation of a dental practice, should be a function of cash flow so long as the practice has a positive cash flow. Here is what the Business Development Bank of Canada (formerly the Federal Business Development Bank) has to say about this:
“The most common method used to determine a fair sale price for a business is calculating a multiple of EBITDA (earnings before interest, taxes, depreciation, and amortization), which is a measure of a company’s ability to generate operating earnings.”
Just so that you know, the Federal Business Development Bank, sometimes called BDC, is Canada’s only Certified B Corporation with loans in excess of $41.2B to over 72,000 Canadian entrepreneurs. They should know what they are talking about!
If you Google “Business Value Equation,” you will find 262M responses – quite a few from which to choose. Try “Dental Practice Valuation,” and you will find 4.8M, a more manageable result but still more than a thousand years of reading, assuming you could get through 10 a day. In truth, there are various ways to estimate the value of a dental practice, and not surprisingly, some are better than others, and some not rooted in cash flow can be very misleading. However, if we stick with the BDC’s methods, the formula is derived from the following:
EBITDA = VALUE X RETURN ON INVESTMENT
VALUE = EBITDA ÷ RETURN ON INVESTMENT (ROI)
VALUE = EBITDA X EARNINGS MULTIPLE (the reciprocal of ROI)
EBITDA: EBITDA (earnings before interest, taxes, depreciation, and amortization) is very similar to Net Profit except that certain otherwise normal expenses have been removed. The objective is to arrive at a business’s normally expected annual cash flow from operations before tax. In fact, there are situations where EBITDA is not a good measure of a company’s cash flow (i.e. you do have to pay your taxes and service your debt, both of which require cash, and from time to time, you do need to replace your equipment and leaseholds). What allows the EBITDA model to work for dental offices is that their financial structure is very basic. For the most part, dental offices are sold with no long-term debt and only equipment, leaseholds, inventory, and goodwill. Additionally, the EBITDA from one practice to another is typically comprised of the same elements, making it easy to compare the operating results of one practice to another.
The only change that is made to EBITDA other than removing the expenses noted above is that the earnings are adjusted (Normalized) to remove discretionary, one-time expenses, or otherwise non-normal expenses. This is a process called normalization and, if done properly, will allow for a reasonably accurate comparison of one practice to another.
EBITDA is generally calculated by taking third-party accountant financial statements and removing long-term interest, taxes, depreciation, amortization (similar to depreciation), and other non-operational expenses.
RETURN ON INVESTMENT & EARNINGS MULTIPLES: Any astute investor will expect a return on their investment. Determining such returns is a complicated process and depends on the type of investment, prevailing interest rates, and state of the industry type (in this case, a dental practice) of the investment. Fortunately, we are only dealing with one industry type – dental practices. Without complicating the process, let’s assume that the expected return on investment will be 16.67%. So, according to our formula above, to estimate the value of a dental practice, we would divide its EBITDA by 16.67%. As it turns out, people would rather multiply than divide, so if we take the inverse of 16.67%, we end up with a “Multiple,” which for 16.67% is 6.00. Multiplying the EBITDA by 6.00 will produce the same result as dividing the EBITDA by 16.67%
The suggested Value Equation, therefore, is:
VALUE = EBITDA X the EARNINGS MULTIPLE
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. Understanding what goes into determining practice value should help you focus on the things that will drive the value of your practice. Make sure you read our collection of blog posts on Incremental Revenue. Check back often because there will always be something of value here whether you are selling or not.
Contact: Written by Derek Hill CPA., CA., Broker of Record
If you would like more information about this or any other articles written by Derek Hill please contact Derek Hill at firstname.lastname@example.org. For other articles by Derek Hill, you can visit the Hill Kindy Practice Sales website at www.hillkindy.com.