Getting Down to Dollars and Cents
A look at the most commonly used valuation formulas and what they really indicate about your practice's value.
This is the third in a series of four articles which will guide you through the process of valuing your practice. Each article in this series will build upon the information introduced in the previous article to help you see the full picture when valuing your practice.
The information will vary from factors to consider to strategies for improving your practice's value. The series will help you accurately value your practice and make changes to increase its value.
So you think you know what your practice is worth. You've found one of the standard valuation formulas and have plugged in all the numbers. Now you're banking on that figure for your selling price, and you're already counting on the profit. But before you commit to this amount, think twice.
When a consultant performs a practice valuation, he usually applies many different formulas. And after he completes all aspects of the valuation, he has much more detailed information than I can provide here.
This article is meant to give you a broad overview of common formulas used, but keep in mind that everyone uses variations on the standard formulas.
Depending on which valuation formula is used, the numbers can greatly vary. So what do the figures tell you? Do they realistically indicate your practice's value? Can you count on selling your practice for this much?
At best, the figures you derive from calculating one of these formulas will give you a starting point. This knowledge is a pivotal step in better understanding your business. Yet, doctors tend to put all of their stock into the figure derived from a valuation formula. This just sets the stage for disappointment because these figures don't usually represent the ultimate selling price.
Starting with the basics
Before you can even begin calculating any practice valuation formulas, you'll need to have some basic practice information in order. You need complete, accurate and up-to-date financial documents (a current balance sheet, income statement and statements of cash flow) to complete an accurate valuation. If you don't know how to create these, seek help from a certified public accountant, or a financial or practice consultant.
The first step in any valuation is determining the true book value and cash flow for the practice by analyzing the balance sheet and scrutinizing your practice's assets and liabilities. Primarily, focus on equipment, furnishings, inventories and accounts payable and receivable.
Also, analyze your income statement and statements of cash flow to make an accurate determination of income, expenses and net income. Recasting expenses is also necessary to determine a more accurate bottom line net income. To do this, evaluate which expenses won't be incurred by the new owner or that are specific to you. Then, figure these into the income equation.
Balance sheet analysis
A balance sheet is a financial statement that breaks down assets, liabilities and net worth. Consider it a snapshot of your practice's financial health. To determine the current market value of your tangible assets, you'll need to have the items appraised.
Also, a practice's tangible assets should provide a current return to the owner -- comparable to what the owner could earn if the amount for tangible assets were invested elsewhere with a similar risk and return. A breakdown of typical tangible assets might look something like this:
- lease provisions
- equipment and instruments
- furnishings and fixtures
- physical inventory.
Valuation formulas don't take into consideration many aspects of your practice, including intangible assets (e.g., growth rate of practice, community characteristics, hours of operation, staff characteristics), but just because you can't add these characteristics to a formula doesn't mean that they shouldn't play a role in helping to determine the value of your practice.
For example, say a practice is old and rundown but has a great location. The location is a huge asset. You need to evaluate how all of these factors interplay.
Income statement analysis
An income statement is a financial statement summarizing all the revenue and expense transactions that result in a profit or loss over a period of time. This is also a critical tool for determining the financial well-being of your practice. In the sample practice we'll use to calculate the different valuation formulas, an analysis of sales, income and gross profit for the past 4 years would appear as in Table 2.
After you examine certain aspects of the income statement, you need to further analyze your net income as reported. Then, recast your expenses.
To do this, add up expenses incurred by the seller owner that are discretionary, non-cash expenditures or of a one-time nature. Depreciation of equipment is an example.
Several income statement adjustments (adjustments to net income) are then necessary to derive a reasonable and comparative earnings before interest and taxes. From now on, I'll refer to earnings before interest and taxes as "EBIT" to save space.
EBIT is calculated by taking the net income plus recast expenses less a reasonable salary for the purchaser. The numbers in Table 3 were used to derive 4 years average EBIT (Table 4).
Once you have an accurate EBIT, you're ready to select and apply a valuation method.
Using a sample practice
I'll highlight the five most common practice valuation methods, using the example of a practice that has a median gross practice income of approximately $350,000.
According to the American Optometric Association's publication "Caring for the Eyes of America 2000," the median gross income per practice is $345,000 and is $307,000 per O.D. Now whether this seems high or low, remember that the median (the amount that falls exactly in the middle of the range) probably best represents the typical earnings, although individuals' incomes may vary substan- tially from the median. The distribution of incomes tends to skew toward a small proportion of very large incomes, and this is what causes the average (mean) income to exceed the median.
The valuation formulas I'll discuss include the Debt Service method, the Formula method (IRS Revenue Ruling 68-609) and three methods referred to as Rules of Thumb, which are sometimes referenced specifically within the optometric industry. Other "Rules of Thumb" methods exist, but the ones I've chosen most closely affect the practice value for the typical practice selected as the example.
Debt Service method
The Debt Service method I use quantifies the maximum amount of debt a practice could pay, reduced for taxes, and based on current and adjusted earnings. Because this method uses current earnings, as adjusted, it should represent an affordable amount a purchaser could pay from the income generated by the practice. Our Debt Service computation begins with EBIT for the years 1997 to 2000.
Using these figures, the new owner of this practice could expect to base first year total cash flow on the figures shown in Table 9 .
With this method, the value of the practice is $285,000. With an annual average EBIT of $48,000, this would support purchasing a practice of $285,000 at 11% over a 10-year payback period.
The Formula method, also referred to as I.R.S. Revenue Ruling 68-609 and sometimes referred to as the Excess Earnings method, was developed by the U.S. Treasury Department and is commonly used in valuing small businesses.
From a conceptual point of view, this method computes the practice's equity value based on the appraised value of tangible assets, plus an additional amount for intangible assets, both of which we discussed earlier.
Using the Formula method, we derive a value of $234,455 for the practice (see Table 10).
Rules of Thumb methods
As I mentioned before, there are other "Rules of Thumb" methods, but these three are the most applicable to the practice example we're using.
- Rule of Thumb 1 -- Average of the last 4 years' gross income.
- Based on these figures (Table 11), the value of the practice using an average of 4 years' gross income would be approximately $342,750.
- Rule of Thumb 2 -- Computed value of the practice as five times EBIT, which derives a value of $240,000 (average EBIT of $48,000 x 5). See Table 12.
- Rule of Thumb 3 -- Computed value of the practice as 50% of the last 2 years' average gross revenues for intangible assets plus an amount for tangible assets. Here, the practice's value would be about $307,000 (hard assets of $130,000 plus goodwill of $177,000). (Table 13.)
Tallying the numbers
After applying the various valuation methods based on the mock practice we created in the beginning, here's what we find:
The $281,841 value determined by averaging all methods may give us a fair starting point. Keep in mind, many management experts say that the average practice is worth 70% of the last year's gross income. If we apply this method here, then the practice would be worth $251,300.
We have many methods to choose from. So, which one is right? All? None? Neither because after applying these sophisticated formulas, we're left with a value on paper. So what really matters when determining practice worth? I'll give the answers in next month's conclusion.
You can reach Dr. Rumpakis via e-mail at firstname.lastname@example.org.