Some dentists think there is a “right” price for every dental practice on the market. They assume dental practices are like home values, where someone out there with the right formula can input some numbers into a calculator and get the “fair appraised” value for any practice available. The appraisal is therefore the gospel truth. These dentists know, just like buying a house, the two parties might haggle a bit over the sales price, but the anchor point of the negotiation is the appraisal.
In reality, valuing a business, including a dental practice, is a much more subjective process than most dentists realize.
Let me share how valuations work in reality with a quick story from my MBA program.
I learned how business valuations work in one of the most difficult finance classes in the country. Week in and week out our professor drilled us in the various methods of valuing a business—discounted cash flow, multiples method, comparable transactions, market valuation, sum of parts method, etc. We showed up each week with our models and had them mercilessly torn apart by the professor. He had to be tough! He was training the next generation of Wall Street bankers. But I was learning the “right” way to value a business. On the last day of class, I learned all that work would be put to a different use than I expected.
Our professor ended the semester by saying, “Every valuation you do outside of class will be complete bull. To get hired by a client to even do the valuation in the first place, you’ll need to sell them the story that you can get a buyer to pay more than any of the other brokers out there. You’re going to tell the client a number of how much their business is worth and then you’re going to back into that number by choosing the model and assumptions that get you the number the client wanted to see in the first place. And the client will only be happy if they get that number.”
He was saying the valuation is completely made up!
A broker I know well mentioned to me recently how the price was set for a new listing he called me about. He told me how the seller had found a buyer off-market and the buyer had agreed to a price of $810,000. The buyer got close to closing but backed out for personal reasons. The seller then called the broker.
The way the broker described it to me was, “So my choice as the broker was to promise either $810,000 or another bigger number. Or else he wasn’t going to hire me and he’d go find another buyer on his own.”
But this doesn’t mean the seller and broker got out their calculator and used a valuation methodology to come up with that number.
If you’ve seen a valuation number for a dental practice, it is a series of assumptions piled on imperfect information. The seller hired that broker, in part, because the broker convinced him she could get him the most for his dental practice. Oh sure, the number needs to be believable. It can’t be totally crazy and needs to fall within an acceptable range. But the formula isn’t as precise as some dental buyers assume.
So how do you know what a dental practice is really worth? Technically, the only way to know for sure what a practice is worth is to find a number a willing buyer will pay to a willing seller. Once you and a seller agree on the price, you’ve found the “right” value for the practice.
That said, you don’t want to be ripped off. The two methods I use to see if clients are paying a fair price are:
- Price to Gross Revenue
- Price to Earnings
Price to Gross Revenue
This method describes how much you need to pay for the collections of a dental practice. This is the method most people are familiar with. It basically says, “How much will I pay for a dollar of collections?” The historical average of that number is the average buyer pays the average seller is 69.87% or $0.70 (rounded up) for $1.00 of collections. Put differently, if a practice collects $1,000,000, then it sells for about $698,700. While that is the median number, that figure includes ALL practice sales nationwide – including the large number of practice sales for smaller practices many readers here wouldn’t be interested in. The more common range of valuations with this method that I see is between 75-90% of collections for good practices.
Price to Earnings
This method describes how much you need to pay for the earnings of a dental practice. It says, “How much will I pay for a dollar of net income from the practice after all the expenses are paid.” Earnings are how much the practice has left over after expenses, but before any pay and perks of the doctor. The historical average here says buyers pay about $1.61 for $1.00 of earnings. Put differently, if a practice has annual earnings of exactly $100,000, the average buyer in the US will pay $161,000. Like the other method, the more common range of valuations for good practices here would be between 1.75-3.0.
Which Method is Better?
You should put significantly more weight on the Price to Earnings method. I care more about how much money I’m keeping after all my work than I do about how much the practice collects. True, you want to know both numbers to know if you’re getting a good deal on your dental practice.
While my goal with practice valuation analysis is to help a buyer pay a fair price for a practice, I will frequently help buyers keep the big picture in perspective. Remember you don’t make most of your money buying and selling dental practices. Oh sure, you definitely don’t want to overpay when buying a dental practice. But, the real money in dentistry comes in the year-in, year-out ownership of the profit stream from the business.
If they’ve found a good practice that isn’t as profitable as it could be, I tell my clients to think about the profit stream of the business as the primary consideration. Use the Price to Earnings methodology to negotiate and bring the seller down a bit on price, if necessary. But, if you like the city the practice is in, your spouse likes the area, the building is good, the staff seems good, the equipment isn’t junk and you think you can make it work . . . don’t get hung up on which valuation method you use to value the practice.
Don’t overpay, but don’t make the mistake that you can mathematically figure out the perfect value of a dental practice.