I am often asked, “How do you appraise a dental practice?” and “What percent do you use to get the price?” If the process were that simple, we wouldn’t need experts in practice appraisal, just a calculator that can multiply two numbers.
Professional appraisers approach the task of every appraisal with the same principles. In each case, appraisers consider the three formal approaches to value — the Asset Approach, the Income Approach, and the Market Approach.
Each approach has various methodologies that are applied, but the appraiser’s experience, judgment, and study of the individual practice determines which approaches and methodologies to apply or discard in establishing the final price.
The three approaches
The Asset Approach determines practice price by assessing the values of the practice’s tangible and intangible assets. This method is not as simple as it may seem, as there are multiple asset values for just the equipment. Equipment has 1) a basis or acquisition price, 2) a book value (basis value adjusted for depreciation), 3) a replacement value (the cost of buying comparable new equipment), 4) an in-place value (in a working office generating income), and 5) a street value (if the equipment were put in a warehouse and sold). Given the complexity in valuing tangible assets such as equipment, consider how difficult it is to accurately assess the value of intangible assets such as goodwill, which constitute the greatest majority of dental practice value.
The Income Approach calculates the price a buyer can afford to pay for a practice, given the practice revenues, expenses, debt service, and a commensurate purchaser income.
The income approach method often used to value dental practices with stable earnings is the Single Period Capitalization Method. The Multiple Period Discount Method is applied in practices when earnings have not yet stabilized. The firm I work for prefers the amortization of earnings method, as it is less sensitive to subjective judgment and more accurately measures the actual price a buyer can afford to pay.
The Market Approach is a major determinant of the fair market value of a practice. With the market approach, the appraiser identifies similar practices that have actually sold and applies the price/gross ratio of those practice sales to the subject practice. The most valid statistic to use in comparing practices is the price/gross ratio. Applying the price/gross ratios of similar practices that have actually sold to the subject practice provides a market approach price for the subject practice. The most important comparative qualities for practices are the demand for the location, practice cash flow, quality and quantity of the equipment, office attractiveness, and the fee for service versus managed care. Successfully applying this approach depends on having a sufficiently large database of transactional data and the ability to identify true comparables. Too many times appraisers apply the overall average percentage of all practice sales, not realizing that only 3% of all practices were sold at the average percentage. The bell curve of price/gross ratios is very broad and very flat, and requires that each practice be examined on its own merits.
Since buyers rarely pay more than the market bears or more than they can afford for a practice, the final result for most practice valuations is the lower of the market approach or the income approach. The asset approach is rarely used for an ongoing practice because it’s usually applied to an inactive practice or a brand new practice that does not yet earn a profit. The principle of substitution applies in non-profitable practices, since buyers usually prefer to purchase an equally priced practice that has some cash flow versus a start-up practice with no cash flow.
Some appraisers average the results of different methods, which is as logical as mixing silicon and alginate impression materials to get a better impression. In the case of appraisals, there is usually one method that gets to the heart of value much better than others, and its importance and precision should not be degraded for the sake of using all of the values that the appraiser derived.
A professional and accurate appraisal is the result of much study, judgment, experience, and deliberation, which not only provides a final price, but proves why that price is the only logical result.
Earl M. Douglas, DDS, MBA, BVAL
This entry was posted on Thursday, December 5th, 2013 by Earl Douglas and is filed under