What if I told you that your practice was worth $2.2 million? You're a 58 year-old dentist who's eyeing retirement, and you use this figure in calculating annual income and begin making plans for those upcoming years full of both adventure and relaxation.
Seven years later, you are ready to sell. There's one problem – the highest offer from any buyer is $1.2 million. Your practice revenues haven’t dipped, the economy is still strong, and interest rates remain low. What happened to that $1m?
The problem wasn't the market at the time of your sale; rather, it was in my valuation of $2.2m seven years prior. You see, I'm an educated guy with an MBA and a master's in economics. I took some of the lessons I learned regarding cost of capital and business valuations and applied them to your dental practice. I even looked at your financial statements and here is what I saw:
Practice Revenue: $1.6 million
Net Income: $250,000 (15 percent profitability)
You built an impressive practice and I wanted to let you know what it's worth. So, I made some assumptions (and this is where it all goes wrong). First, I assumed the $250,000 that you were cranking out in net income every year is repeatable no matter who steps in to your shoes. There is no key-person risk because every dentist is exactly the same with similar efficiency and capabilities, right?
Next, I assume the cost of capital at 11 percent. In my finance class in my first year of my MBA, I learned that cost of equity capital is calculated by taking the risk-free rate of return (2.49 percent on a 10-year Treasury Note) plus a risk premium based on the industry or business. I used 8.51 percent as the risk premium for dentistry and feel like I have captured all the risk with an 11 percent cost of capital. Now, I remember watching Shark Tank a couple times and Mark Cuban would take the net income he thought was repeatable and divide it by the cost of capital to come up the company's valuation. If I do this, I find that your dental practice is worth $2.2 million ($250,000 divided by 11 percent).
Unfortunately, if we go on to Shark Tank and pitch your practice at $2.2 million, we are going to get laughed out of the room. And why? As savvy entrepreneurs and investors, the Sharks know that there is a huge key-person risk in your practice and the $250,000 in annual net income is not guaranteed once you sell. Your relationship with your associates and staff, your efficiency as a dentist, and your ability to run the business all walk out the door the day they purchase it. Yes, of course there is another dentist that will replace you – but who's to say the patients will appreciate his style and philosophy or that the staff will relate and respect him from day one? There is risk in the cash flow because the main source (you) is leaving. In addition, because dentistry relies on third-party payers (insurance companies), an additional risk to cash flow arises. If payment policy should change at the big insurance companies in coming years, the practices cash flows may be negatively impacted. A 10 percent cut on procedures makes a big difference. If this were a widget company, the departure of a manager and presence of a third-party payer may not matter; however, dentistry is a service industry and your role, as well as the reliance on insurance payments, is paramount to your practice’s success and cash flow.
The second error in my assumptions was understating the cost of capital - otherwise known as the expected return a purchasing dentist would require on the money he uses to purchase your practice. Eleven percent is certainly a reasonable return on equity and, seeing as how the S&P 500 has returned 10.31 percent annually from 1920 to 2014 1, it's not off base to expect similar returns from equity capital. However, when the dentist invests in the stock market, he is a passive participant with almost immediate liquidity. He’s not required to show up every day and manage the positions and if he ever needed the money, he could exit with the click of a button and have it wired within the hour. This is not the case if the dentist buys your practice. He must be an active participant and will have minimal liquidity. Even if he found another buyer to purchase at such a high valuation, it would take months to get the deal done. I should have used a much higher cost of capital due to the illiquidity premium and business risk. The higher cost of capital would have reduced my valuation of your practice.
I failed you seven years ago, but you see, I really wanted to appease and give you good feelings about your practice's value. I should have looked at the recent sales and understood how practices were valued in real life. If I had a pulse on the buyers in the market, I would have realized that my valuation was far off the mark and a more reasonable approach existed. Specifically, I would have seen that dental practices are commonly sold as a percent of average revenue, not as a 9X multiple of net income. In fact, dental practices have been commonly selling between 68 percent and 75 percent of the average three-year revenues. In some cases, they can go for more or less, but it is due to unusual circumstances of a particular practice such as geographic location or opportunity for expansion. If the market and experience were my guide, I should have valued your practice in the $1.2 million range (72 percent of revenues) and you could have more appropriately planned for retirement.
Instead, you're going to be appalled when there exists no buyers for your practice and scrambling to find someone to explain how it all went awry. Unfortunately, the market is always right. When buyers and sellers agree and a transaction occurs, it provides irrefutable evidence on the value of a practice – and it gives those involved a glimpse at the market. Each transaction gives more and more insight in to the market for dental practices and the best methods for valuation going forward.
Fortunately, there are transition and CPA firms, like Edge Advisors, who understand the market and root their valuations in reality backed with years of expertise. Over the past 5 years, we have had the pleasure of being a part of over 80 dental transitions and are the best in the business. The success of private practice dentists is what keeps us going.
Remember, anyone can provide you with a valuation, but it doesn't amount to a hill of beans unless it can be sold at their stated price. When working with any consultant or advisor, make sure they are compensated for what they accomplish for you, not how they make you feel. It is better to hurt by the truth than to be comforted with a lie.
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• Not adjusted for inflation.
• Shiller, Robert. "Online Data." Robert Shiller. Yale University, n.d. Web. 31 July 2015