There are many methods people use to value dental practices. By far the most overused and problematic of the methods used is the “rule of thumb” methodology.

Essentially a rule of thumb valuation method is a simple formula that you can apply to all businesses within a particular industry in order to work out its selling price.

Common rules of thumb that you hear used to value dental practices is that a practice is worth either 30-50% of gross for goodwill, plus the value of the equipment or approximately 70% of the gross turnover of the practice.

People like using rules of thumb valuation methods for two main reasons:

1. They are quick and generally anyone can plug in their practices figures to find a valuation within minutes as opposed to getting a professional valuation done by a company that specialises in dental practice valuations which involves analysis of the practice and can take weeks.
2. They are free.

To understand what is wrong with relying on a rule of thumb methodology when you are buying or selling a practice we first have to look at what “rules of thumb” formulas are and where they come from.

A rule of thumb formula for valuing a business is really an industry average that is worked out by looking at the sale prices from many businesses in the same industry (In this case dental practices).

What’s wrong with a rule of thumb methodology?

There are many things wrong with relying on a rule of thumb method to value a practice you are going to buy or sell.

The rule of thumb averages may be accurate for those practices whose performances are.....about “average”. The practices with expenses and profits that are right on target with industry averages, or are in an “average” socio-economic suburb, with “average” equipment may well sell for a price in line with the rule of thumb formula. Others will vary greatly. By strictly applying the rule of thumb you could be grossly under or overvaluing the practice.
Using a rule of thumb formula will no doubt save you the price of a professional valuation ($2000-$3000 depending upon who you use) but it can easily cost you tens of thousands of dollars if you relied on it in establishing a practice sale price.

1. An average may not be very representative of individual transactions. Let’s say we looked at 100 dental practices that were sold over a two-year period, average all the selling prices and calculate that the average dental practice sold for 58% of one year's gross income. A rule of thumb is thus created. However, some of the 100 dental practices may have sold for 80% one year's gross while others may have sold for half of one year's gross.
2. Metro vs Rural. Practices in metropolitan areas like Sydney and Melbourne are much more in demand and attract higher prices than identical practices in rural areas. However, using the two examples of rules of thumb formulas for practices given above a practice in Sydney and Alice springs with the same gross turnover would have the same value. This should not be the case.
3. Risks and opportunities. A rule of thumb cannot factor in risks and opportunities related to the specific practice, premises and location. For example a rule of thumb will not be able to factor in:

a. A short lease whereby the practice will have to move in the near future.
b. Housing development being built nearby increasing the potential patient base for the practice

    4.  Timely fluctuations. New factors can and do influence the selling price of all businesses (including dental practices) on the market. For example:

a. interest rate fluctuations
b. ease of borrowing money,
c. corporate entities buying into dental practices enmasse

Using a static rule of thumb does not take industry fluctuations over time into account.

Conclusion
There are many more examples that can be shown where rules of thumb fail to account for differences between Practices. A professional valuation will at a minimum assess these differences and account for them appropriately in determining fair market value.

Rules of thumb are useful in determining whether you are in the ballpark.
If you want to be on base, I suggest a professional valuation.

If you enjoyed this article you might enjoy these other articles we have on practice valuation:

• icarus effect on practice sales
• The fish was this big! ...and other valuation distortions