Various methods of appraisal have been used through the years. Some of the methods have fallen out of favor, and more sophisticated appraisal methods have evolved. To establish the most accurate value possible, a combination of methods is recommended.
Securing an earnings stream is the primary motivation for a dentist to purchase a dental practice. Income approach derives a relationship of your earnings to the value of your practice. While multiple methods should be applied to determine an accurate value of a dental practice, the income approach is often the favored method for determining what drives value in today’s marketplace.
The first step is to differentiate between what the current owner/dentist earns for tax and personal reasons and what another dentist (buyer) would actually earn. The past three years’ income and expenses need to be carefully examined. Revenues and expenses are normalized to exclude unusual items, or items not necessary to operate a dental practice (i.e., depreciation, interest, personal insurance, automobile expenses). After making all the necessary adjustments, a revised net profit for each of the three previous years is determined.
The second step is to determine the investment earnings of the practice. A practice owner receives compensation not only for producing dentistry, but also as a return on investment. We must compensate the practitioners of a practice a fair salary for services provided to the patients. A figure of 25 percent to 35 percent of revenues for services provided by the dentist is typically a fair and comparable salary. To determine the investment income to the owner of the practice, subtract the compensation for the services rendered by the dentist from the normalized net profit determined in the first step. This income stream is what drives value in the practice.
Capitalize Investment Earnings
The final step is to capitalize those investment earnings. To do this, arrive at an appropriate capitalization rate. Think of the capitalization rate as the minimum rate of return necessary to induce an investor to buy or hold the dental practice. The proper capitalization rate will equal the rate of return a buyer would expect by investing in the dental practice as opposed to some other investment with less risk, more liquidity, and fewer administrative concerns.
Determining the proper capitalization rate is one of the most difficult procedures in valuation. In dentistry, variables include specialty, practice size, location, experience, and number of staff. No standard table of capitalization rates applies to different types of dental practices. The capitalization rate for a dental practice typically varies from 18 percent to 25 percent. The more positive attributes the practice possesses, the lower the capitalization rate it receives, and in turn the higher the appraised value. A capitalization rate of 25 percent means the purchaser could recoup his or her investment in four years.
A capitalization rate of 20 percent means the purchaser could recoup his or her investment in five years. The determined capitalization rate is applied to the weighted average of the previous three years’ investment earnings to determine the appraised value of the practice.
Fair Market Value
The fair market value of a practice is not necessarily its sales price. It is a knowledgeable and quantifiable estimate of what a practice sales price would be assuming all factors of the definition of fair market value are correct: Fair market value is the price, in cash or equivalent, that a buyer could reasonably expect to pay and a seller could reasonably expect to accept, for the assets of a practice placed for sale on the open market for a reasonable period of time, with buyer and seller each being in possession of all of the pertinent facts and neither being under compulsion to act.
Several factors including tax allocation, post-closing employment, terms of the transaction, personalities of the dentists, quality of representation, and emotions have a significant impact on the final sales price of the practice in any given transaction.
It is understandable why business owners, including dentists, desire a simplistic formula to determine the value of their businesses. However, every dental practice is distinct and no one formula or method is universally applicable.
Just as every patient requires a thorough examination, diagnosis, and treatment plan, it is imperative to assess the current condition of the practice and the numerous factors that influence the market value of that practice in order to determine its value.
Peter Ackerman, CPA