How are Practices Valued?

EBITDA* x Earnings Multiple = Practice Value

Valuation methodologies vary somewhat, but from a simplified perspective, practice value is derived from a multiple of earnings (EBITDA), either a trailing EBITDA, based on the practice’s historical performance or a forward-looking EBITDA, based on an estimate of the purchaser’s expected future earnings.

* What is EBITDA?

EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortization and is basically the cashflow generated from the business before taxes and loan repayment. Practice value is based on an adjusted EBITDA, which incorporates several adjustments, eliminating any discretionary costs to reflect the true cashflow of the business independent of the owner.

As you can see from the sample “adjusted EBITDA” calculation below, the following costs are removed: ʚ All personal/discretionary costs (e.g., dentist and family wages; personal cell phone expenses and personal insurance etc.) ʚ Any costs associated with the dentist rather than the business (e.g., interest, automobile; travel, meals and entertainment; licenses, fees and dues; and continuing education etc.) ʚ Any non-cash expenses (e.g. amortization). Furthermore, dentists’ compensation is built-in at a standard market rate (e.g., 40% of all dental billings) to account for the fact that any purchaser would expect to earn at least what they would as an associate in practice.

How is the Earnings Multiple Determined?

Whereas the earnings are derived from the practice, the earnings multiple is determined by the market and is a range, with the specific multiple impacted by a variety of factors related to the practice, economic environment, type of market etc. For example, an attractive practice with new equipment and a great location would likely sell for a higher multiple than a practice with less ideal attributes even with the same EBITDA. A seller’s market drives competition, often yielding multiple offers for good practices, bumping up the earnings multiple buyers are willing to pay. Interest rate hikes put downward pressure on earnings multiples because borrowing becomes more expensive, meaning most buyers can’t offer as much for a practice.

Asset Valuation

Sometimes the practice value will be presented in the format of an asset valuation, which is the sum of the value of all the practice assets: goodwill; equipment; instruments and supplies; and leaseholds. Assigning value to the tangible assets is relatively straightforward, for example, equipment value is typically market value adjusted for depreciation; leaseholds are based on a dollar amount per square foot and instruments/ supplies are often a percentage of annual supply costs. Conversely, goodwill being an intangible asset is more difficult to quantify, and therefore different brokerages have their own proprietary methods for valuing goodwill. Technically, the goodwill calculation is just a subtraction exercise, the enterprise value (overall practice value) derived from practice earnings less the value of the tangible assets equals goodwill. If a more arbitrary approach has been used to determine goodwill, then it’s important that you consult your accountant to ensure the method makes sense.

One specific situation where an asset valuation may be used is when practice value derived from the earnings is less than the value of the tangible assets. In these cases, the practice value may be based on the value of the tangible assets plus a price per patient for goodwill.

Keep in mind that an asset valuation without an accompanying cashflow analysis demonstrating sufficient funds to support the loan payments will make it challenging to secure bank financing.