There are generally three methods of valuation for businesses. Dental practice valuations sometimes utilise a fourth method, a rule of thumb.
It is a surprising fact that the rule of thumb method for valuing a Dental Practice is still not only used, but somtimes used as the sole method of valuation.
A quick search on Google will provide an amazing amount of information with regard to the rule of thumb method. Basically it is a valuation approach whereby the practice's Gross fees are multiplied by a percentage to arrive at a valuation figure. On the very first page of a Google search for the valuation of a Dental practice, there are percentage rates from 50% to 80%. This means that if your practice turnover is in the region of $1,500,000, it will be worth between $750,000 and $1,200,000 if you rely on this information. This is immaterial of the quality or value of the equipment, the location or the current economic climate. Thankfully, just because a rule of thumb valuation arrives at these figures, there is no guarantee that a "willing and knowledgeable buyer"* will pay the valuation amount.
Similarly, the market or comparison approach of valuation falls short of an acceptable method. This approach simply compares a practice with other practices that have sold to determine the value of the practice. The theory behind this method is that a ready, willing and able buyer has paid a certain amount of money for a practice and the seller has sold for that amount of money. I have been selling businesses since 1986, and apart from the sales evidence information I have seen being extremely unreliable, I have never seen a business so similar to another business as to make this method acceptable.
The market approach method should be very rarely used because of the extreme difficulty in finding truly comparable business sales. Even when non-listed business data is available, it is often meaningless, as pertinent factors are frequently omitted.
The third method used is that of the cost or asset approach. The asset-based approach utilises the businesses adjusted balance sheet as the primary focus of fair market value. This approach is important where the fair market value of a business's assets is significantly greater than its book value. The asset-based approach may be considered when valuing a controlling interest with significantly appreciated assets such as real estate. It may also be utilised when there is very little or no profit shown by the business, but there are significant tangible assets.
Before looking at the fourth method, it is perhaps helpful to look at the reason behind why you would want to know the value of your Dental practice. The three major reasons are:
- Bank purposes
- Family Law purposes
Each of the above reasons may well dictate the approach used in the valuation. however all three will certainly base the valuation on one crucial aspect of the business, that of profitability.
The fourth method is the income method. The Income approach is based on determining the future income streams expected from the asset under valuation. It is the most widely used approach, as the information necessary to determine the value is readily available and accurate.
The parameters used are:
- Future income stream
- Duration of the income stream
- Risk associated with the generation of the income stream.
To value the income stream, Discounted Cash Flow (DCF) is used.
Discounted Cash Flow analysis is a method of valuing a project, company, or asset using the concepts of the estimated income streams and discounted to give their present values (PVs) – the sum of all future cash flows, both incoming and outgoing, is the net present value (NPV), which is taken as the value or price of the cash flows in question.
The discount rate used is generally the appropriate Weighted average cost of capital (WACC), that reflects the risk of the cashflows. The discount rate reflects two things:
- The time value of money (risk-free rate) – according to the theory of time preference, investors would rather have cash immediately than having to wait and must therefore be compensated by paying for the delay. Typically in Australia the 10 year day Treasury Note is used as a risk-free rate. This rate was 2.81 % as at 11th of June 2018, but changes almost daily.
- A risk premium – reflects the extra return investors demand because they want to be compensated for the risk that the cash flow might not materialize after all. This risk premium takes in to account market conditions that exist at the time of sale, the location of the practice, the value and condition of the equipment, staffing, customer data bases, and computer systems amongst other factors.
Once the discount rate is applied to the averaged adjusted profit of the business, the resultant figure is the value of the business. This value includes all stock, plant and equipment, other tangible assets, and of course goodwill.
* The mostly recognised and accepted standard of value is fair market value. The definition of fair market value is the cash, or cash equivalent, price for which property would change hands between a willing buyer and willing seller, neither being under any compulsion to buy or sell and both being adequately informed of the relevant facts.