Purchasing a Practice – The 4 Methods of Valuing a Practice

There are a myriad of ways to calculate the value of the practice. Although some methods may be used more than others, there is no “100% correct way” of valuing a practice. Ultimately the value of a practice becomes a mutual agreement between the potential seller and potential buyer. The buyer assumes it to be a price that will demonstrate a substantial return, while the seller assumes it be a price that is fair given the potential that has been built. Let’s dive into the methodologies used to calculate a practice’s value.

There are four total accepted ways to derive the value of a practice. Each method provides a distinct perspective on revenue:

4 Methods of Valuing a Practice

1) Revenue Stream Method
2) Capitalization of Earnings Method
3) Net Plus Assets Method
4) Debt Service Model Method

1) Revenue Stream Method

It is common practice to evaluate a practice based on a percentage of the previous year’s gross collections. In fact, the Journal of the American Optometric Association states that “ …the average practice valuation of optometric practices… is 58.7% of gross income of the year preceding the sale of the practice…(others) have noted that the price paid for a practice is typically 40% to 70% of the gross income of the year preceding the sale of the practice…”.

In order to derive your percentage multiplier of gross income, it is important to go through a careful analysis of expenses in all major categories to make sure they are within normative values for an office of its size, location and demographic.

Many things must be considered when benchmarking practice norms and the “zip code” is of great significance.  It is expected that a practice in the rural midwest will net a significantly higher amount than a practice in a major metropolitan area. The cost of staffing and occupancy can be as much as 10% higher for these urban areas and as a result will have a direct effect on the net income of the practice as well as the valuation itself.

Occupancy expenses including staffing costs are other important factors to look at when using the Revenue Stream Method.  Also, cost of goods sold plays a factor. All of these aspects of a practice are linked to net income, which in turn casts its large shadow over picking your percentage multiplier of gross.

Purchase Price = 58.7% or X of Gross Revenue
(X being adjusted based on a variety of cash flow factors)

2) Capitalization of Earnings Method

The Capitalization of Earnings Method is a common method which attempts to convert the practice income stream into a single lump sum value that represents both goodwill and assets of a practice. In others words, what would be a reasonable amount for a buyer to pay to receive a projected annual profit?

To create this scenario, this method compares the practice as an investment as compared to alternative investments available to a potential purchaser.

The formula for Capitalization of Earnings Method is listed below:

Purchase Price = Adjusted Earnings/Capitalization Rate

Now a few definitions in order to better understand this formula.

Adjusted Earnings - The true earnings of the owner of the practice, minus the cost of paying an optometrist reasonable compensation to provide services in the owner’s practice.  Earnings are not merely judged by the amount of the salary paid to the owner. It includes several benefits that have monetary value to them, including but not limited to: personal health insurance, automobile expenses, continuing education, retirement plans and even loan payments that go to increase the level of the owner’s equity.

Capitalization Rate - The capitalization rate, or “cap rate”, is a numeric value derived to approximate the risk associated with the continuation of the cash flow of the practice. This is usually derived as a percentage that the earnings are divided by to determine the final value of the practice. The most common method of determining the cap rate evaluates the different risk factors of investing in an optometric practice versus other forms of investments such as mutual funds, stocks, etc.

Elements that increase the risk of purchasing a particular practice will decrease its value, and vice versa. However, many of the risk factors associated with the purchase of a professional practice versus the purchase of other types of investments can be considered benign. For example, a given buyer could find several risk factors such as demographics or heavy competition negligible if they are set on a certain geographic area.

Here are some of the risk factors considered in determining the capitalization rate for a given practice:

  • Area demographics

  • Physical office location

  • Competition from area eye professionals

  • Financial production and trends

  • Patient flow – both new and existing patients

  • Seller / Bank financing

  • Number of years in business at present location

  •  Value of medical and office equipment

  • Existing and future lease terms

3) Net Plus Assets Method

Purchase Price = Average Adjusted Profit + Physical Asset Value

A time proven method of appraisal that weighs heavily on the actual physical assets of the practice is the net plus assets method. Traditionally, the asset value is determined from information obtained from depreciation schedules on the company tax returns. The condition of the equipment and leasehold improvements can als be taken from those values. It should be noted that unless an individual evaluation of each asset was performed, it would be impossible to ascertain their exact value.

Here are a list of specific asset values to look at:

  • Equipment

  • Furnishings

  • Inventory values

  • Leasehold improvements

At the time of closing it is recommended that another inventory be performed and if the value is 10% greater or less than the published value below a compensatory adjustment should be made to the final purchase price.

4) Debt Service Model Method

The debt service model looks at the ability of the business to service debt above reasonable compensation for optometric services. The model uses a term of 10 years at 5.0% interest representing standard financing terms in the commercial lending market today for a practice with similar cash flow and asset values that exceed goodwill.

Purchase Price = (Annual Adjusted Earnings x 10 years) - 5% Fixed Interest Rate for 10 years

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About Dr. Aaron Neufeld

Dr. Aaron Neufeld is a Co-Founder and editor for ODs on Finance. He owns a group private practice in Los Altos, CA and values a debt-free lifestyle as well as serial investing in real estate and index funds. Contact him: aneufeldod@gmail.com

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