3 Factors that Affect Valuation
Buying or selling a dental practice is a major decision with lasting impacts. Dentists rarely turn over the keys and walk away from operations – the process is much more of a transition rather than a transaction. It is important to remember that a transition must be financially rewarding to both parties. There are many deal terms to consider and having both experienced advisors and motivated parties creates an environment conducive to a successful transition.
Selling a dental practice starts with answering the question: “How much is my dental practice worth?” The answer to this question is mainly a function of three factors – cash flow, growth, and risk. HORNE’s Jarrod Barraza takes a dive to further unpack these factors. Take a look below to learn more!
Investors are primarily interested in cash flow when making decisions. Cash flow is closely related to profits, but they are not identical; valuators must convert anticipated profits to anticipated cash flows. The valuation of a dental practice includes the difficult task of projecting future operations and discounting these projections to a single present value using a subjective discount rate. Most often, recent history serves as a reasonably basis for the future, but that need not be the case in all situations (such as anticipated dentist/hygiene turnover).
The valuation of a dental practice focuses on the amount of cash able to be distributed to owners after necessary reinvestments are made to continue operations rather than the profits generated by the practice. Thus, a practice with higher anticipated capital expenditure needs or higher anticipated net working capital requirements will generate lower cash flow available for distribution – which would result in a lower valuation (all else equal).
Cash flow can also be generated through expense reduction, though not all reduction measures are viewed with similar risk. Certain overhead expenses may be easily controllable, whereas projecting cost saving measures in labor expenses might be much less certain (more on risk later).
All else equal, higher risk is generally associated with achieving higher levels of projected growth. However, not all growth factors are created equal. If growth is expected to be achieved through a recently hired associate or hygienist ramping up, this growth would likely be viewed as less risky than growth projected from opening a new location at a yet-to-be-determined office at a yet-to-be-determined date, or expansion to offering new services to which no historical data is available.
Another growth element of a valuation is the long-term growth rate, which is a necessary simplification to avoid projecting a perpetual stream of cash flows. At some point a valuation assumes the dental practice has achieved a stable state of operations, and that the cash flow available to investors will grow at a constant rate forever.
There are differing opinions on a reasonable long-term growth rate, but most valuations use a range from 2% to 5%. Naturally, all else equal, a higher long-term growth rate assumption would lead to a higher valuation.
Risk can be addressed in different aspects of the valuation. For example, risk can be – and should be – addressed in the projected cash flows themselves by assessing the results of different scenarios into the analysis. If competition is a major risk due to a new practice opening in the area, the valuation should consider the potential impacts of decreased revenues and offsetting cost savings efforts.
Risk may also be addressed in the discount rate, which refers to the rate of return used to convert expected future cash flow streams to a single present value. These rates of return represent the percentage return on investment that a market participant would command for investing in the subject dental practice. The adage of “higher risk, higher [expected] return” generally holds true, as markets are assumed to be at least somewhat efficient in the long-term.