When someone is looking to buy or sell a practice, they are often presented with an appraisal of the practice that has been prepared by the other party in the transaction. While the results of the practice’s trading may be clear, there are numerous appraisal techniques to choose from, and often some creativity applied when using them.
Terms like “production/revenue”, “profit”, “EBIT” and “expenses” are of course fundamental to any valuation technique, and there should be an objective universal definition of what they mean. Unfortunately, as you will see, they can be manipulated by people who are self-taught or trying to push their own agenda.
Here are some of the creative approaches to valuations that can distort value.
1. Average of the past 3 years’ production or profit.
Some people will attempt to value a practice using a calculation that includes an average of the past 3 years’ production or profit.
For a buyer, the most recent year should be far more relevant, interesting and worth much more consideration than the years that preceded it. Someone using the average of the last 3 years’ production or profit in their calculation is understating the importance of up-to-date information and dampening it. This could be intentional or not.
The distortion this creates is:
- If a practice is growing over time, averaging the last three years could reduce the valuation.
- If a practice is slowing over time, averaging the last three years could increase the valuation.
People who average results over three years say that their rationale for this is to dampen the effect of an unsustainable spike or temporary decline in fortunes. However, unless there are undisputed reasons to suspect that the most recent year’s figures are unsustainable (the cancellation of CDDS, or CDBS for example) or a temporary lapse it is extremely difficult to be conclusive about whether a recent one-year spike or decline is temporary or the start of a trend.
If no good reason is given for the averaging of 3 years’ figures in your valuation calculation, then to do this is to dilute the most valuable information unnecessarily. If the previous year’s results are considered in a valuation, it should be using a weighted average, where the most recent results are worth more than previous results.
2. A Vendor’s invisible income
A practice is said to be valued using invisible income if its calculation includes revenue:
- that the practice has collected in cash (and was never invoiced).
- that the practice would have collected if they hadn’t given discounts.
- that the practice would have collected if the principal had worked more (if they are inflating the revenue because the principal took more time off in his last year in hours per week or weeks per year).
- that the practice would have collected if the principal had done clinical work that they can’t do (if I did ortho the production would have been $XXX…).
Invisible income is money that the practice didn’t verifiably receive. No one can prove it came in, or that it would have come in if the principal worked more or didn’t give discounts. As such, it cannot be counted in any serious practice appraisal and would inflate a valuation without verifiable merit.
3. A Buyer’s discounted income and discretionary expenses
A practice appraisal can be deflated unnecessarily if a buyer:
- tries to discount income from clinical work that the buyer isn’t interested in or doesn’t do. For example, the buyer appraises the work without implant income, or orthodontics if they themselves don’t do implants, or orthodontics.
- Tries to deduct discretionary capital improvements that they would want to make post sale (e.g. a refit or a fit-out and equipment of another surgery).
The true value of a practice is what it would be able to achieve if it was put to wider market. Not what it is worth to a specific buyer. If the wider market could replicate the clinical skills of the exiting dentist, there is no reason to discount it. If capital improvements are not necessary to operate that practice and achieve the results that it is being sold under (if they are discretionary), there is no reason to include them in an appraisal.
4. A Vendor’s invisible expenses
Sometimes a practice’s value may be inflated by invisible expenses. This can happen if a practice’s calculation of profit includes discounted expenses that won’t be passed on to the purchaser. The most common invisible expenses include when the vendor:
- Owns their own premises and isn’t paying themselves the same level of rent that they would charge to someone else if they sold the practice.
- Is paying themselves less than market rate for their services (i.e., less than 35-40% if they are a dentist).
- Has family members working for them and is paying them less than a market rate salary and/or having them do tasks for free that the purchaser would need to pay someone to do.
5. “The fish was this big”
There is no established database of what businesses sold for or what valuation techniques were used to value them. Dentists asking around trying to identify market knowledge are often left with unreliable narration by buyers or sellers trying to make themselves look better in the story. Buyers have been known to understate what was paid and sellers have been known to overstate what they received (or leave out the onerous terms and conditions of the sale) in order to make themselves seem more astute at negotiation.
Buyers and sellers valuing a practice based on half-truths communicated from a party to a transaction like this could be wildly underestimating or inflating a practices value.
Conclusion
While formulas do exist for valuing a practice, it is important to realise that:
It is impossible to reduce every practice in Australia to a single formula that can be used across the board in every circumstance. Every valuer will tell you that there are different methodologies that are more appropriate in different circumstances.
There are a lot of attributes of a practice like opportunities and risks that affect value and cannot easily be put into any formula. For example, A formula cannot account for a big residential development going up nearby or one suburb being more attractive to buyers than another. A formula also cannot account for underutilized or overutilized attributes of a practice.
The variables in some of formulas are prone to creative interpretation (As seen above) by amateur valuers.
While the parties to a transaction may want to save themselves some money by using “established valuation techniques” to come up with a price via a Do-It- Yourself Valuation, by doing so that they may be costing themselves far more. There is no substitute for independent arms-length appraisals or market testing the practice via competitive tension.
If you enjoyed this article you might enjoy these other articles we have on practice valuation: