Part 3 - Valuation Myth By Michael Njo, DDS
The past two articles have walked you through what your timeline and exit strategy desires are, the second article walked you through putting your team together to achieve and facilitate your goals. Now let's discuss the nuts and bolts of a valuation. This process will either add or detract from a successful purchase. Who does valuations? Or should I say an "Opinion of Valuation". Unlike a piece of real estate, Dental Valuators are generally not licensed. Brokers or transition consultants do not generally have a license to valuate practices.
The asking price is what a seller would like to receive, the offering price is what a buyer is willing to pay, and the appraised value is what an appraiser provides as an educated opinion of value. In common parlance, we refer to fair market value as "willing buyer, willing seller." This is very important because until we have a willing buyer and a willing seller, we don't have a deal. As important as willing buyer and willing seller are, the other very important elements are that "neither party is under any compulsion and that both parties have reasonable knowledge of the relevant facts." The compulsion issue stands alone.
There are rare situations where death, disability, or some other event can cause the seller to be under pressure to sell, but pressure is not compulsion. On the other hand, having knowledge of the relevant facts is another issue entirely. This is where a valid appraisal performed by a qualified appraiser using legitimate and accepted appraisal methods is critical. It is also where the buyer and seller perform their own due diligence and take some of the responsibility of understanding the implications of entering into a transaction. A legitimate appraisal with explanations and justifications will greatly assist both parties in making these assessments. There is a big difference between facts and feelings. I have cared for so many buyers who feel the practice is too expensive and have taken care of many sellers who feel that their practice is worth a lot more. Facts are information in the form of data that can be written, verified, and replicated. Feelings, on the other hand, are just that. One person may feel a particular way, and another person may feel an entirely different way. Both feelings and facts are important in the decision-making process, and neither should be less valuable when establishing a selling price for a seller or analyzing a practice to buy by a purchaser.
If the data is not there or suggests a deficiency in the practice, that fact must be reflected in the value. If the feeling is not there, it may not be reflected in the offer by the buyer. One buyer may feel warm and fuzzy whereas another may not. Feelings are subjective, so we will leave the feelings out of the analysis process. Since facts and data are objective, we can look at the numbers and analyze, compare, and project to help us to arrive at a value. But the numbers are only one component of value. The other component is risk. Value is a function of net income and risk. Risk is the subjective component to the process of appraising in contrast to the numbers, which are objective. What is important to understand is that without the objective component, there can be no knowledge of the relevant facts, and without the subjective component, there is limited reasonable knowledge.
Without getting into the complexities of the different processes used in valuing professional practices, it is possible to review, in a generalized manner, the methods used, and the information required to perform an appraisal. The terms appraisal, valuation, and opinion of value may be interchanged. The important thing to remember is that to be considered an appraisal, certain specific information about the subject practice has to be known and analyzed. If an opinion of value is made without the necessary information, the representation of value is most likely the result of using a rule of thumb. A rule of thumb is a generalized estimation that may not be precise or, for that matter, even representative of actual value.
An example of a rule of thumb is: "A practice is worth 70% of gross income." To show that this is not a valid opinion of value, let's look at two practices, each grossing receipts of $800,000. Using the rule of thumb, both practices would be worth $560,000. However, if one practice has an overhead of 50% with the dentist taking home $400,000 and the other practice has an overhead of 70% with the doctor taking home $240,000, are they equal in value? Of course not. Another example is using the same practices with $800,000 in gross production and both having an equal 50% overhead, but one has all new, state-of-the-art equipment and the other has old, outdated equipment. Again, these two practices are certainly worth different amounts, even though they provide the same amount of income to the dentists. Knowledge of the relevant facts suggests that the information is available and has been analyzed correctly. To achieve a proper analysis, it only makes sense that someone who is qualified to do the analysis does the analysis.
It would not be appropriate for an attorney to diagnose and suggest a treatment plan to a dental patient, nor would it be appropriate for a dentist to interpret the law. So, what are the methods of valuation? There are two universally accepted approaches for valuing dental practices. The first is the market approach. The market approach to value uses comparable previous sales of like practices to determine value, much the same as real estate appraisals use comparable sales of real estate to establish value. This approach is the most accurate and most defendable method of valuation. It is hard to argue that like practices do not have reasonably like values. It is information such as this above that provides us with the ability to compare a proposed value to that of other transactions in order to confirm that the value arrived at using other methods of valuation falls within the reasonable parameters of the marketplace. It is also information, such as the above, that allows rules of thumb to be used or misused instead of using legitimate appraisal methods. It is easy to use the market data and derive a percentage of gross as the going market value, when, in fact, the previous examples show how other factors impact the actual value of the practice.
The second universally accepted method of valuation is the capitalization of earnings approach. The capitalization of earnings approach uses the concept that a multiple of earnings or the capitalization of earnings represents a legitimate return on investment and therefore a legitimate value. Capitalization converts earnings or excess income to value. The problem that must be solved is, what are earnings? In a dental practice, the earnings are always distributed to the owner(s). Therefore, no earnings are identified, and with no earnings, there is no value. To address this, it is necessary to analyze and adjust the income and expense statement to determine the actual required expenses that are necessary to operate the practice and the usual and customary salary that would be paid to a dentist if he or she were to be hired to perform the dentistry in the practice. In most cases, this will result in some income left over that can be capitalized. This process requires someone with knowledge of dental practice management, industry standard expense norms, and acceptable salary ranges to do the analysis. Once a true net income has been arrived at by analyzing and adjusting the income and expense statement to reflect real practice income and expenses, we have to apply the risk factors that impact value. As stated before, value is a function of net income and risk. Risk factors include many things, such as local and national economic conditions, age and condition of equipment, location, types of procedures, staff competence and experience, size of the practice, percentages of managed care and reduced fee dentistry, specialties and specialty procedures in a general dental office, location, facility lease conditions, and practice systems.
Practice systems reflect the management and transferability of the practice. Systems consist of scheduling, number of active and new patients, charting, recall, and accounts receivable management. All these issues need to be analyzed and the risk associated with them determined before a value can be arrived at. If the systems in a practice are not functioning properly, a buyer is less likely to want to purchase the practice or will pay less for it. As such, a disorganized practice would lend to the point that higher risk yields lower value. The size of a practice can also be a risk factor. If the practice is grossing less than $300,000 per year, it is likely that there will be little, if anything, left for a buyer after the operating expenses and the debt service (payments for the money borrowed to purchase the practice) have been paid. Not many buyers are willing to buy a practice if they cannot take home a reasonable salary. Considering taxes will still need to be paid on the earnings, it would be hard to live on less than $70,000, raise a family and pay off school loans. Because of this, the commercial lenders are reluctant to finance a practice purchase where the take home is so low even if a purchaser is willing to buy. On the other hand, a practice grossing $1,200,000 or more requires an experienced clinician and administrator. This experience is not readily available in most new buyers, thus once again creating greater risk in selling the practice. Because fewer and fewer specialists (as a ratio of the population) are graduating, it has become easy in many locations to start up a practice from scratch, reducing the available buyers, and thus creating a greater risk of selling a specialty practice. Specialties within a general practice also create risk.
For example, if a practice has a significant portion of the production generated by a specialty such as TMJ, CAD CAM, Holistic, or orthodontics, it is hard to find a buyer who is qualified and has the same philosophical approach to the specialty as the seller. The same issue exists for any specialty practiced within a general practice, including pediatric dentistry, endodontics, implant surgery, and periodontics (usually large soft-tissue management programs). If, in fact, there is significant specialty practiced within a general practice, the portion of revenue generated by the specialty may have to be carved out of the gross production, thus reducing the gross production and concurrently net income to the practice, thereby lowering the value.
The liquidity of money is usually determined by the prime interest rate, the cost of borrowing money (lending fees), treasury notes and bonds, and T-bill rates. The reason these are used in the appraisal analysis when considering risk is to provide a comparison to the risk of investing money in something other than a risk-free instrument. Treasury instruments are considered risk-free because the government would have to collapse for a default to occur. So, if by investing in a dental practice, the return on investment (ROI) is equal to or less than putting the same money into a Treasury instrument, it would be foolish to invest in the dental practice. The converse is also true, however, that if investing in a dental practice the return is greater than putting money into a Treasury instrument, then the risk can be justified.
All of the above factors need to be evaluated in order to develop a capitalization rate (cap rate). This number is properly arrived at by what is called the build-up method. The build-up method takes into consideration all of the risk factors and builds them up to a percentage number that is used as a denominator which is divided into the adjusted net income (the numerator) with the resulting number as the value. Other methods that are common to the appraisals of other businesses and industries but are
not usually appropriate for dentistry are the discounted future earnings approach, the amortization of earnings approach and the asset summation approach.
All of this information is provided to communicate that there is a formal process accepted by the professional communities for determining a practice value. If these accepted practices and processes are not used, the asking price by the seller or the offering price proffered by the buyer may not have any basis of support and, most likely, cannot be justified.
In summary, it is very possible to legitimately determine the value of a dental practice. To do this, there are two accepted and legitimate methods, the market approach, and the capitalization of earnings approach, which, when determined, represent the value of the whole practice. If these methods are used correctly by skilled appraisers, the value of the practice arrived at in the appraisal will cash flow. One thing that should be mentioned is that when interest rates are very high or very low, or net income in a practice is very high or very low, the impact on the build-up method to arrive at a cap rate will force the practice value out of the market range. Therefore, the true test of value is always the question, "Does the value fall within the market range, and does the practice cash flow at the appraised value?"
That question brings us full circle to: "Will a buyer buy, and will a seller sell if both have reasonable knowledge of the relevant facts?"
