Whether you’re looking to buy a new dental practice or you want to sell the one you currently own, determining the practice’s value is an integral step of any transition. Many different methods and valuation formulas are used to determine a dental practice’s worth. Such formulas generally consider three main factors: risk of investment, return on investment, and cash flow. For the best results, a professional dental practice transition consultant should implement a combination of a variety of valuation methods. To better understand how the value of a practice is determined, consult this guide to dental practice valuation methods.
The importance of determining your practice’s value
In a dental practice transition, determining the value of the practice is essential for the selling and purchasing parties. This will help shape negotiations regarding the transition and ensure that both parties get a fair deal. Unfortunately, many dentists don’t have an accurate estimate of the value of their practices, which can result in lost funds for both parties.
Importance for the buyer
- When someone embarks on the journey of purchasing a dental practice, an accurate valuation of the practice will help them determine if the acquisition is an affordable and beneficial investment.
Importance for the owner
- For the doctor who’s selling their practice, understanding its value will help them with financial planning and ensure they aren’t leaving any money on the table. Even if a dental practice owner isn’t planning on selling in the near future, having their practice appraised periodically can still be beneficial. By knowing the value of their practice, they can better understand its net worth, plan for retirement, and develop an effective emergency exit strategy.
Dental practice valuation methods
Capitalized earnings method
The capitalized earnings method is a commonly-used method that’s based on the income of the practice. To determine the value of a dental practice using this method, you’ll need to average the practice’s net income from the previous year or the past few years. The net income takes into account factors such as operating expenses, collections, and professional compensation; these expenses are deducted from the average annual net receipts. After the net income has been calculated, the residual average excess earnings are divided by a risk factor known as the cap rate. In the dental industry, this rate is typically around 20 to 30 percent. After you make these calculations, you’ll have an accurate estimate of the practice’s investment value.
Average annual earnings method
The average annual earnings method is very similar to the capitalized earnings method; however, it doesn’t factor doctor compensation into the percentage of doctor production. To calculate the average annual earnings of a dental practice, consider the practice’s net earnings that are available to the owners. Typically, the annual net earnings will be based on the past three years. This number is then multiplied by a percentage based on recent sales and purchases of other dental practices in the area. In a non-rural community, the value of a practice will usually fall between 150 and 200 percent of the average annual earnings available to the owners.
Net asset value method
Another way to determine the value of a dental practice is to base calculations on the appraised value of the practice’s tangible and intangible assets. Tangible assets—which may include real estate and dental and office equipment—are typically expressed at a percentage of their original cost to account for depreciation.
The majority of the value of most dental practices, however, lies in intangible assets such as practice goodwill. This aspect will generally account for roughly 80 to 85 percent of a practice’s value. This percentage depends greatly on the location of the practice, patient demographics, supply, demand, and other factors. Because goodwill is often difficult to appraise, the net asset value method isn’t always the most reliable for all dental practices. However, if your practice has significant real estate holdings or is experiencing financial issues, this method may be advantageous. The net asset value method should be used in conjunction with other valuation methods to assure greater accuracy.
Discounted cash flows method
With the discounted cash flows method, the valuation of the dental practice is based on the net present value of the projected net income for the next 10 years. The projected incomes are determined based on a reasonable growth rate of collections and yearly practice costs. After the incomes are calculated, they’re discounted by an estimated cost of capital in addition to a risk premium, which typically ranges from 23 to 31 percent for dentistry. Like other income-based methods of valuation, the discounted cash flows method is ideal for practices with a proven history of substantial revenue and growth as well as a sizable patient base.
Annual net receipts method
Also known as a market-based valuation method, the annual net receipts method is helpful for quickly analyzing collection trends. To determine the annual net receipts, you must calculate a percentage of the average annual net receipts over the past three years. To do so, you’ll use information based on the market data for other dental practices that have been sold in the area in the past few years. Typically, the percentage utilized for this calculation will fall between 50 to 80 percent of the average annual net receipts. The reason for this wide variation is largely because this method focuses solely on collections and considers neither profit nor the time and expenses required to produce the collection. Furthermore, finding comparable practice sales figures can be difficult. As such, the annual net receipts method isn’t always the most accurate method of valuation when used alone.
If you’re interested in selling your practice, Henry Schein Professional Practice Transitions can help. As a dental and oral surgery practice transition planner, we understand that knowing the value of your practice is the first step to a successful transition. As such, our effective seven-step approach begins with a formal, comprehensive dental practice valuation. To ensure that you have the smoothest and most beneficial dental practice transition possible, contact us today.