I
Annuities in Ancient Rome
There is a world of difference between the way economics looks at the valuation of a business entity and the way the dental transition industry does. In the economic world, a repeatable cash flow or net income stream acts like an annuity going on into the future while in the dental transition world, a business entity (dental practice) is worth a proportion less than a stated amount of last year’s revenues or net sales. How a business entity that will be throwing off cash for the next ten to thirty years is restricted to one that threw off cash only last year is one of the marvels of the inconsistency with economic tradition that marks the cottage nature of the treatment of the dental industry by transition brokers.
Rich in tradition and history as dentistry is, you would think the dental industry would love the concept of an annuity. As you read the history of the twelve Caesars in Imperial Rome, you realize how the Caesars managed to persuade legions of soldiers to subscribe for battle campaigns that grew the size of the Roman Empire and made Roman names as popular in other parts of Europe as they were in Rome. The soldiers and their families were assigned an annuity instrument sponsored by the Roman Senate that said, provided the soldier was not dishonorably discharged for events itemized on the back of the instrument, such as AWOL or failure to fight nobly, etc., the soldier and his family would receive an annual stipend of a stated amount (1010 of ancient Greek currency) for the remainder of the soldier’s life. So, if a soldier at 22 returned from battle three years later at 25, he and his family would receive 27 annual stipends of so much gold (aureus), silver (denarli), and bronze (asses) over the soldier’s 48 years of life.
For the Roman solider, the 27 years of payments have the following value which the table below translates as dollars. The actual currency is ancient Greek with a 1010 annual annuity payment in ancient Greek money giving a total valuation in ancient Greek currency of 93,045.29.1 Ninety-three thousand reasons to serve Caesar!
II
Annuities for Repaying Student Debt
Other than for the soldiers having the guarantee of the Roman Senate, how different is the Roman scenario from modern dentistry? The dentist subscribes to four years of indentured servitude to a University Dental School for which has as his or her promise the return in the form of the income and/or salary from utilizing the skills learned in Dental School. These skills will on successful application allow him or her to become a state-licensed dentist. The dentist, however, unlike the Roman soldier, isn’t paid for his or her four years of servitude. He or she had to pay the Dental School for the privilege of serving. Thus, six-figure student loan debts have become pretty standard for the modern dentist moving forward into the practice of dentistry.
With ancillary costs for books and lodging and per diem on top of tuition, today, four years of dental school roughly runs to about $100,000 per year, or a debt load of $400,000 to the graduating dentist. This demonstrates a soaring upward movement from the average debt load of $200,111 in 2010, according to research by the American Dental Education Association. Considering the modern dentist starts with a salary of around $125,000 a year, his or her debt load is more than three times salary.2
A $400,000 loan balance with an estimated interest rate of 7.5 percent would result in a $4,748.07 monthly payment if the loan term is 10 years. Look at how remarkably similar in format is the graduating dentists obligation to the bank from the Roman Senate’s obligation to a returning solider and his family.
Close to a million reasons why banks offer dental school candidates student loans!
III
Annuities for Valuing your Dental Practice
Assuming the graduating dentist has grinded through his student loan repayments, worked his way into either a partnership position where he can take both a salary and share income, or, on the basis of having paid off the student loans, obtains a 100 percent bank loan to buy his or her own practice, the concept of return on investment for all this effort hinges on what his or her practice is worth at specific periods of time when he or she wants a leave of absence, wants to consolidate debt, wants to expand to a multi-facility operation, or just wants to retire.
Here’s where the same concept of the annuity which prevailed in ancient Rome, defined a debt obligation for the student loan, comes back into play in determining the worth or value of his or her practice. His or her practice is worth the principal of an annuity of an annual cash flow or net income number in a template identical to our Roman solider.
Below, we take as annual Net Income $250,000 per year from the practice owned by the former graduate. This is income and not salary and is repeatable so that it can be expressed as either a long-term annuity of 10-30 years or more, or as a perpetuity, since, after 30 years, adding more years doesn’t really add that much more to the value of the principal of the annuity sum.
It is important to note that the 2% interest rate compounded per period for ten (10) years in the Table generates an add-on to the $2,500,000 of principal ($250,000 X 10) of $237,430.25. This is equivalent to a nominal annual rate of interest of 11%, ($237,430.25 ÷ $2,500,000.)
This “interest” is the return that belongs to the buyer, not the seller. Therefore, the selling or year 0 annuity valuation of a dental practice throwing off $250,000 of annual net income can be captured by the perpetuity formula with an 11% interest rate.
Perpetuity Formula: Net Income ÷ Interest rate
$250,000 ÷ 11% = $2,272,727 3
This is how economics evaluates a business entity. The only matter remaining is the denominator, or interest rate, to be used in the perpetuity formula.
IV
Cost of Capital
Above, the future value of an annuity table used a 2% compound interest rate while the present value annuity table (the perpetuity formula) used an 11% nominal interest rate. Which rate, if either, is the correct one to use to value your dental practice? Neither.
The correct rate is the cost of capital. Cost of capital refers to the opportunity cost of making a specific investment, here the buyer interested in purchasing a dental practice being put up for sale. It is the rate of return that could have been earned by the prospective buyer by placing the sale price money for purchasing the dental practice into a different business investment with equal risk. Thus, the cost of capital is the rate of return required to persuade another dentist or other kind of buyer with interest in the dental industry to buy your dental practice.
Given this opportunity cost definition, in the present climate where a risk-free investment is defined as the nominal yield on a 10-year treasury bond at 2.49%, a nominal 2% cost of capital for quantifying a dental practice value is not a useable rate. 11% is more plausible, adding an 8.51% risk-premium for venturing from investing in a risk-free treasury note to investing in a risky solo dental practice.
Group practices would receive a less painful risk-premium, and for guidance on the applicable rate to use we can go to the empirical data-keeping at such investment houses as Value Line and Cap + IQ. These are conveniently made available by the NYU Stern School of Business at: http://people.stern.nyu.edu/adamodar/New_Home_Page/datafile/wacc.htm.
An industry cost of capital line item exists in the NYU Stern data set for “healthcare support services.” Given the documented attraction of group dental practices to the DSO/Private Equity market, this line item is a good proxy for a risk premium. The cost of capital is given as 7.08%, meaning a 4.59% risk premium exists for investing in a group instead of a solo practice.
Therefore, economics would value a solo practice throwing off $250,000 per annum against a group practice throwing off $250,000 per annum in the following manner:
Solo: $250,000 ÷ 11% = $2,272,727
Group: $250,000 ÷ 7.08% = $3,531,073
The penal nature of being a solo instead of group practice is likely even more severe owing to the fact that a group practice usually outperforms a solo practice. The illustration below is probably more realistic as to the valuation of each set of business entities.4
Solo: $75,000 ÷ 14.49% = $517,598
Group: $250,000 ÷ 7.08% = $3,531,073
The risk-premium of the solo practice (at 12% on top of the risk-free rate) may appear severe, but transition brokers routinely quote the risk premium of a solo practice as high as 17.51% over the risk-free rate. A 20% cost of capital is argued for by a number of CPAs and other who do valuation work in the dental industry. Personally, I believe 20% is way too high. Since a higher cost of capital means a lower valuation, these experts are largely responsible for keeping the price of solo dental practices unreasonably low serving the benefit of a quick sale and the handing over of a new practice to a potential new client.
V
Conclusion
Rome wasn’t built in a day, nor was valuation theory in economics. We have the seminal work of two Nobel Laureates, Eugene Fama and Merton Miller, to thank for pulling together the centuries of documentation and research on this subject in their classic, The Theory of Finance, published by the University of Chicago Press in 1972. For empirical verification of the theory of finance, valuation experts are forever in debt to the immortal work of Fischer Black carried on admirably in the 21st century by Aswath Damodaran of the NYU Stern School of Business.
Annuity and the valuation of annuities have a long, rich tradition which has direct applicability to the valuation of dental practices. Why we have labored so long under the misapprehension that a dental practice is only worth a portion of its prior year sales is one of the conundrums of the transition industry having no support or foundation in the analysis of valuation to be found in economic literature.
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1 Calculation is from the website available at: http://www.calculatorsoup.com.
$1,010 is the number for annual family income of soldier in ancient Rome per historical documents, available at: http://webcache.googleusercontent.com/search?q=cache:h9GRKXh7XL4J:gpih.ucdavis.edu/files/BLW/Roman_Empire_14.doc+&cd=2&hl=en&ct=clnk&gl=us. The 8.33% interest rate is from Michael Hudson, ““How Interest Rates were Set, 2500 BC – 1000 AD,” available at: http://michael-hudson.com/2000/03/how-interest-rates-were-set-2500-bc-1000-ad/. Interest rates then were a municipal concept, not an investment device.
2 The $400,000 is high for a national average, although applicable in many instances to the grander dental schools. From the ADEA website, we learn: average debt for all indebted dental school graduates in the Class of 2014 was $247,227. Over 30% of indebted dental school graduates in the Class of 2014 reported debt in excess of $300,000.
3Some readers of this valuation section may be unfamiliar with use of the abbreviated perpetuity formula, being more familiar with discounted present value and its formula:
Where "C" stands for net income," j" is the date of valuation, "r" is the interest rate, and "n"is the number of years quantified. However, when "C" is the same number every year, this formula mathematically reduces itself to the perpetuity formula: V = Cj ÷ r.
4 For a solo practice with revenues reported last year of (say) $700,000, for the first time we see the economic rationale behind the transition broker’s idea that a dental practice is worth some proportion of value less than its annual total revenue base of the prior year; here, at 74% of prior year revenues.