When Valuing Your Practice, Do Not Rely on the Rule-of-Thumb

For many dentists, their biggest asset is their practice. Still, many are unaware of its true worth when it comes time to sell the practice.

This is the issue: many dentists believe the commonly used 0.8x or 0.6x rule-of-thumb method is the way practices are valued. The truth is that this method only provides a guestimate of the practice’s value. The result is that $1 million or more may be left on the table. That is a lot of money to walk away from. Rather than risk it, dentists should consider having a valuation professional perform a certified valuation.

The major difference between the two valuation methods is that a rule of thumb valuation measures what the practice is currently worth based on a single measure, such as gross income, while a certified valuation takes a broad view and includes an analysis of the practice’s future value. A formal valuation provides a clearer picture of what the practice is worth by factoring in tangible and intangible information such as gross income, net income, fees charges, location, goodwill, whether the practice takes insurance, which insurance it takes and whether the practice is gaining or losing patients.

There are rules about how a professional valuation should be performed. To form an opinion of value (sometimes called a conclusion of value), the valuation must use one or a combination of these three approaches:

  1. Asset (or Cost) Approach. The cost approach relies on historical costs. It does not consider unrecorded intangibles. This method determines the practice’s by using the combined fair market value (FMV) of the business’s net assets.
  2. Fair Market Value Approach. This FMV approach compares the practice to the sale price of comparable practices through the use of pricing multiples. These multiples are developed by dividing the comparable business’s price by an economic variable such as operating cash flow. Further adjustments are made for discretionary items.
  3. Income Approach. The income approach converts future expected economic benefits (e.g., cash flow) into a present value. Adjustments are made for discretionary expenses.

Valuations frequently use a combination of the FMV and the income approaches to achieve a realistic picture what it would cost to buy the practice. The formula used to arrive at a value for the practice is:

Opinion of value = operating assets + working capital + fixed assets + intangible assets –  cash and cash equivalents

Additional calculations are used to dig even deeper. These calculations include:

  • Discounted Cash Flow (DCF), compares multi-year projections of the practice’s earnings and cash flows to their present, risk-adjusted value of those cash flows.
  • EBITDA (Earnings Before Interest Taxes, Depreciation, and Amortization) adjustments are made for items such as owner’s compensation, rent, and owner-related expenses as warranted by the specific circumstances of the practice.

Opinions of value are the most reliable method of assessing the value of a practice because they review the most data. Rules of thumb are the least dependable valuation method because they are based on a quick snapshot of only one factor.

The variation between opinions of value valuations and rule-of-thumb estimates can be several-million-dollar range—in the sellers’ favor.

Keep in mind that valuations may be performed, perhaps even required, for reasons other than the sale of a business:  Illness or some other circumstance may force a buyout or sale of the practice, it may be required for litigation such as divorce litigation or a value may be needed for estate and gift tax planning.

The bottom line is that rules of thumb may provide a good baseline for valuing a practice, but more information is needed to provide a true picture. Contact Harlene Stevens, CPA, Dental Practice Lead in our tax group if you have any questions or to discuss further.