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Today, the Capitalization of Earnings method is probably the most appropriate method of valuing a dental practice.
It is one reliable way to determine a “hidden value” -- how much your practice is worth -- from your earnings. The number one reason someone would purchase a dental practice is to secure a stream of earnings. That is why the primary method of practice valuation derives a relationship of your earnings to the value of your practice. Its conceptual basis is the price-to-earnings (P/E) ratios that one finds with common stocks.
The first step of the process is to differentiate between what the owner/dentist earns for tax and personal reasons, as opposed to what another dentist (buyer) would actually do. You need to carefully examine the past three years of your income and expenses. Revenues and expenses are “normalized” to exclude unusual items or items not necessary to operate a dental practice (i.e., depreciation, interest, personal insurance, automobile expenses, etc.). After making all the necessary adjustments, you arrive at a revised net profit for each of the three previous years.
The second step is to determine the investment earnings of the subject practice. A practice owner receives compensation for not only producing dentistry but also as a return on investment in the ownership of the practice. You must compensate the practitioners of a practice a “fair salary” for services provided to the patients. A figure of 30-35 percent of collected fee-for-service revenues for services provided to patients by all dentists employed by the practice is typically a fair and comparable salary for a general dentist. From the normalized net profit determined in the first step, you subtract the compensation of the services rendered by the dentists in the practice to determine the investment income to the owners of the practice. Typically the purchaser is willing to give value for this amount. It is an amount above and beyond what a dentist can obtain in a comparable associate position.
The final step is to capitalize those earnings. To do this you must arrive at an appropriate capitalization rate. Think of the capitalization rate as the minimum rate of return necessary to induce an investor to buy or hold the dental practice. The proper capitalization rate will equal the rate of return a buyer would expect by investing in the dental practice as opposed to some other investment with less risk, more liquidity and fewer administrative concerns; the riskier the investment, the higher the capitalization rate. Determining the proper capitalization rate is one of the most difficult procedures in valuation.
In dentistry, variables include specialty, practice size, location and experience of staff. No standard table of capitalization rates applies to different types of dental practices. The capitalization rate for a dental practice varies between 18 and 30 percent. The more positive attributes the practice possesses in our analysis, the lower the capitalization rate we give it -- and in turn the higher its appraised value. A capitalization rate of 25 percent means that a purchaser could recoup his/her investment in four years. A capitalization rate of 20 percent means that a purchaser could recoup his/her investment in five years.
The capitalization rate is applied to the weighted average of the previous three years investment income to determine the appraised value of the practice.
Peter J. Ackerman, CPA, is a certified public accountant, licensed real estate and business broker and national speaker on business issues affecting dentists. For more information, email Mr. Ackerman or visit www.adsmidwest.com.
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