As a business broker, the most common question I am asked by practice owners is: “What’s my practice worth?” Not too surprising, potential buyers most often ask: “How much should I pay for a practice?” So, how do buyer and sellers determine the value of a practice? There are 3 methods commonly used in determining the answer to these questions:
1. % of Gross Receipts
2. Combination of Assets and Net Earnings
3. Multiple of Net Earnings (SDE)
Below is an explanation of each of these methods.
% of Gross Receipts
When practice owners talk about valuation methods, this is one that nearly always gets mentioned. Conventional wisdom states Optometry practices tend to sell for between 60% and 75% of gross receipts. At least that’s the theory and it would be nice if it were that simple. However, in my experience, basing the value on a percentage of gross receipt can lead to dramatically undervaluing or overvaluing a practice. Let me explain by comparing two practices:
· Practice A: $500,000 in gross receipts, $200,000 in net earnings, sales and earnings steadily rising, mostly new state-of-the art equipment, EHR system in place
· Practice B: 500,000 in gross receipts, $100,000 in net earnings, sales and earnings steadily declining, older equipment, no EHR system
While both practices have the same amount of gross receipts, they clearly have different values. The factors that I listed have a profound impact on value. Furthermore, I would argue that Practice A is worth more than 75% of gross receipts and that Practice B is worth less than 60%. This method may prove to be a good starting point for valuing a practice. But, I would caution you not to rely too heavily on it.
Combination of Fixed Assets and Net Earnings
The premise of this method is that the practice’s two most quantifiable assets are its fixed assets (furniture, fixtures, equipment, and inventory) and its income stream. The formula for this methods looks like this:
FMV (Fair Market Value) of Fixed Assets + 1 Times Net Earnings = Practice Value
I do think this method is far less subjective, and therefore more useful, than basing value on a % of gross receipts. This method can be useful for some practices, especially newer ones that have yet to generate a significant level of gross receipts.
On the surface, this method would seem to be an objective one. However, as you dig a little deeper, you realize that you have to determine the Fair Market Value of the assets. So, what is the FMV of your assets? My guess is if you had your assets appraised by three different appraisers; you will receive three different appraisal figures. That’s because so much of the appraisal process is subjective. So, there is actually is a considerable amount subjectivity in this method. Another drawback for this method is that does not account for some very important intangibles that can significantly impact a practice’s value.
Multiple of Net Earnings (SDE)
The premise of this method is rather straightforward. Your practice is also a business. And nearly all businesses are valued on some multiple of their earnings. The reason for this is fairly simple. Earnings are an objective measurement. Once a buyer understands the earnings of a business, they can determine if purchasing the business for a given price makes financial sense.
Historically, Optometry practices sell for between 1.75 and 3.0 times Net Earnings (or SDE). So, what is SDE? SDE stand for Seller’s Discretionary Earnings and it often differs considerably from the Net Income figure on your Profit & Loss Statement or the Profit amount reported on your tax returns. SDE measures the true earnings of your practice (often referred to as Net Cash Flow). Below is a formula that is used to calculate a business’ SDE:
Tax Return PRE-TAX Income (Net Income)
+ Depreciation and Amortization Expense
+ Interest Expense
+ One Owner’s Salary
+ Non-recurring Expenses (e.g. one-time maintenance, legal fee for a one-time event, etc.)
+ Non-operating Expenses or Owner’s Discretionary Benefits (e.g. owner’s health insurance, auto for personal use, contributions and donations, personal cell phone, etc.)
This SDE figures is then multiplied by a “value multiplier” (typically 1.75 to 3.0 for Optometry practices) to arrive at the value of the practice. Factors influencing the value multiplier include things like geographic location, competitive landscape, and revenue/earnings trends. In a future article, I will address these factors in greater detail and discuss ways you can boost the value multiplier for your practice.