A Step-by-Step Guide to Valuing a Practice

Transcription

1 A Step-by-Step Guide to Valuing a Practice Gary L. Moss, O.D., M.B.A. Part two of series As noted in the first part of this 2-part series (see Practice Strategies, November 2005, Valuing the Optometric Practice), inability to determine the fair market value is a fairly common problem when sale or purchase of a practice is considered. This month s followup article provides a step-bystep process buyers and sellers can use to establish the fair market value of a practice. The process actually involves the averaging of the results of 3 separate valuation approaches: the Here are well accepted methods that both those attempting to sell a practice and those seeking to buy a practice can use to establish the fair market value of the practice being offered for sale. Excess Earnings Method, the Discounted Cash Flow (DCF) Method, and the Market Comparison Revenue Multiplier Method. This 3-tiered approach has become virtually standard in the appraisal industry for the sale of businesses and real estate of all types. Anyone attempting to determine the fair market value of a practice should always use 3 different valuation approaches and then average the results. Before outlining this methodology, it is necessary to follow up on November s review of the factors that must be considered in the course of practice valuation with a review of one final factor business risk which will entail a discussion of capitalization and discount rates. Business Risk Analysis Capitalization rate is a numeric value derived to approximate the risk associated with the continuation of the cash flow of the practice. According to Valuing Small Businesses and Professional Practices by Shannon P. Pratt, Robert F. Reilly, and Robert P. Schweihs (New York: McGraw-Hill), the capitalization rate is any divisor (usually expressed as a percentage) used to convert income into value. Capitalizing, therefore, is Gary L. Moss, O.D., M.B.A., is an associate professor at the New England College of Optometry, and an AOA approved provider of practice appraisals through his Practice Appraisal and Mediation service. He can be contacted at mossg@neco.edu or at (978) Opinions expressed are those of the author and not necessarily represent those of AOA. a process that converts a single flow of economic income into an indication of value, according to Tom West s The Business Reference Guide (Concord, MA: Business Brokerage Press). Expressed as a percentage, the more stable the business income stream, the lower the capitalization rate and, in turn, the more uncertain the business income stream, the higher the capitalization rate. This range or difference in values is reflected in the risk that is inherent in the future earning potential or cash flow stream of the practice. The capitalization rate can be determined by a variety of methods, but one popular way is referred to as the build-up method of comparable return rates for various levels of cash flow risks. The starting point is the risk-free rate, which is the equivalent of the long-term U.S. Treasury Bond market yield. The next level of risk is reflected by the long-horizon expected equity risk premium found in common stock. Added to this is a risk premium for the size of the business in this case, equivalent to the expected small stock risk premium and, finally, a subjective assessment of the risk premium for the lack of liquidity or salability of the specific business under consideration. The sum of all the previously mentioned risk premiums will yield the total adjusted discount rate. This is important because the discount rate will be used in the Discounted Cash Flow method of calculating value part of our 3-tiered valuation process. Discount rate is a rate of return used to convert a monetary sum (or series of monetary sums), payable or receivable in the future, into present value, according to The Business Reference Guide. To determine the capitalization rate, the projected annual growth as a percentage for future practice revenue is deducted from the discount rate. The actual financial calculations used to determine the discount and capitalization rates are beyond the scope of this monograph; however, for the purpose of this example, an informal guide shown in Table 1 will be used to select a capitalization rate based on qualitative judgment of the risks inherent in the ongoing ability of the practice to earn income. The capitalization rate is then applied to the value of excess earnings to estimate the value of practice goodwill and other intangible assets. The more stable the projected cash flows, the lower the capitalization and discount rates. Having established both the capitalization and discount rates, those seeking to establish a fair market value for an optometric practice can use any of several methods and then average the results of all the methods utilized. The example that follows describes how the following 3 methods: Excess Earnings, Discounted Cash Flow, and Market Comparison /06/$ -see front matter 2006 American Optometric Association. All rights reserved. doi: /j.optm

2 52 Practice Strategies Table 1 Informal Guide to Selecting a Discount Rate Practice Revenues Discount Rate Extremely stable 0.12 to 0.16 Very stable 0.17 to 0.20 Stable 0.21 to 0.24 Moderately stable 0.25 to 0.28 Questionable 0.29 to 0.32 Moderately unstable 0.33 to 0.36 Approach Revenue Multiplier can be used to value an optometric practice. The Excess Earnings Method Excess earnings are the earnings attributable to goodwill and other intangible assets, as opposed to tangible assets. The Excess Earnings Method originates from the U.S. Treasury Department Appeals and Review Memorandum (ARM) number 34, adopted to determine the goodwill of a business. In 1968, the Internal Revenue Service replaced ARM 34 with IRS Ruling , which is currently in effect. Table 2 explains the steps to be followed when using one popular version of the Excess Earnings Method. This method is sometimes referred to as the formula method and is often associated with the following remarks: Goodwill can be thought of as the difference between an established successful business and one that has yet to establish itself and achieve success. The price the buyer should be willing to pay depends on the earning power and potential of the business. The price the seller should be content with is the amount considered as compensation for the transfer of intangible values and the surrender of the expected earning power of the business. The seller should base the value of goodwill on the actual condition and earning power of the business, according to the textbook Valuing Small Businesses and Professional Practices. Applying the Excess Earnings Formula Method in the next section to the numbers in the sample practice found in Table 3 (based on a model in Bank of America s How to Buy or Sell a Small Business) should offer some insight on how to determine practice value using the Excess Earnings Method. Example of the Excess Earnings Method There are various ways to apply the Excess Earnings method. The formula offered here is adapted from a model developed by the staff of the Bank of America and outlined in How to Buy or Sell a Business, one in a series of tutorials offered by the bank for small business people. Step 1 Determine the adjusted net fair market value of the tangible assets. In this case, we will use the book value of the fixed assets from the balance sheet, plus the inventory. From this, deduct any liabilities associated with the purchase of the tangible assets. Fixed assets $99,000 Inventory 36,000 Subtotal 135,000 Less Liabilities 25,000 Total $110,000 Table 2 Steps in One Popular Version of the Excess Earnings Method Step 1 Determine the adjusted net fair market value of the tangible assets. This is best performed by a firm that specializes in equipment appraisals. If a fair market appraisal is not possible, book value may be substituted, but caution must be used because a variance in final value will result. As a general rule, equipment and furnishings will depreciate about 20% per year from the original cost and will often stabilize at a salvage value of 15% to 25% of acquisition cost after 5 years. Inventory (including current useable frames, spectacle lenses, and unopened contact lenses) should be assigned a wholesale or replacement cost. Step 2 Estimate the annual earning potential of the adjusted net tangible asset value (figure from Step 1) in an alternate investment. Assume you had the equivalent amount of money instead of the equipment, furnishings, and inventory. If you placed this in a relatively safe investment, how much could you earn annually? Another way to figure out an equivalent earning potential is finding out at what rate of interest you can borrow money. Step 3 Ascertain the normal or median earnings of an ECP in the area. Another figure that can be used is the amount an ECP (working as an employee operating the business) would receive, but caution should be used because this can be artificially low. The going rate for an employed ECP can vary according to the area. Sources to research for these data are the AOA Annual Economic Survey and your state s Bureau of Labor Statistics. Step 4 Determine the adjusted annual net earnings of the business (net income before subtracting owner s salary and taxes). This should include all the personal benefit, both salary and fringe benefits, and personal items taken as expenses the owner receives. Step 5 Determine the extra or excess earning power of the practice. Subtract the net earning power of the tangible assets (figure from Step 2) plus substitute income of an ECP (figure from Step 3) from the average adjusted net earnings (figure from Step 4). The excess earnings are considered the amount of earnings above a fair return on the net tangible asset value. Step 6 Determine the value of the intangible assets of the practice by choosing an appropriate capitalization rate to apply to the excess earnings, which are the earnings attributable to goodwill and other intangible assets, as opposed to tangible assets (Step 1). This rate and the discount rate have been determined previously in the section on Business Risk. Step 7 The final practice value is determined by adding the tangible asset value (figure from Step 1) and the goodwill and intangible asset value (figure from Step 6).

3 Practice Strategies 53 Step 2 Estimate annual earning potential of the adjusted net tangible assets (Step 1). To do this, multiply the tangible asset value by an interest rate that is 2 points higher than the cost of borrowed funds. In this case, add 2 percentage points to the 6% bank loan rate. $110, $8,800 earning potential of tangible asset if the equivalent amount of money was invested. Step 3 Ascertain the annual income that would be required to pay a substitute optometrist to operate the practice being valued. Obtain this information from either the most recent AOA Economic Surveys or your state s Bureau of Labor Statistics. For this example we will use a figure of $105,000. Step 4 Determine the total adjusted annual net earnings (total economic benefit of ownership) of the business by adding the owner s adjusted salary and the practice s net profit (both before taxes), depreciation, and other personal benefits deducted as expenses. This can be an averaged or a weighted average taken of the most recent 2 to 4 years, in this case we will simply use the 1 year s figures in the sample data. Depreciation $18,000 ECP s Pension 4,500 CE, Meals 4,500 Pre-tax profit 130,500 Total $157,500 Step 5 Determine the excess earnings of the practice by subtracting Steps 2 and 3 from Step 4. $157,500 $8,800 $105,000 $43,700 excess earnings or the amount of earnings above a fair return on the net tangible asset value. Step 6 Determine the value of the practice s intangible assets by choosing an appropriate capitalization rate (previously calculated from the informal guide method) to apply to the excess earnings (Step 5). For this example, we will select from Table 4 a discount rate of 24%, less projected annual growth of 4%, to yield a 20% capitalization rate. $43, $218, 500. Step 7 Determine the practice value by adding the tangible assets (Step 1) and the value of the intangible assets (Step 6). $218,500 $110,000 $318,500 indicated value by the Excess Earnings Method. Although this method may appear quite simple, it is relied on quite frequently, but can be easily misused. However, this value alone is not the final value, but it is used as part of an average in combination with the values obtained from the next 2 methods. Table 3 Sample Practice Data Abbreviated Revenue & Expense Statement Data: Gross revenue $450,000 Cost of goods sold (28%) 126,000 Rent (7%) 31,500 Advertising (3%) 13,500 Insurance (2%) 9,000 Depreciation (4%) 18,000 Staff salaries (17%) 76,500 Phone, utilities (3%) 13,500 ECP s pension (1%) 4,500 Other expenses (4%) 18,000 Dues, magazines (1%) 4,500 Continuing education & meals (1%) 4,500 Total expenses 319,500 Less: ECP salary (29%) 130,500 Net profit (loss) $0 Total effective tax (26% $130,500) $33,930 Abbreviated Balance Sheet Data: Cash (3%) $13,500 Accounts receivable (5%) 22,500 Inventory (8%) 36,000 Total current assets $72,000 Fixed assets (22%) 99,000 (While this calculation typically uses book value, a more useful figure may result from using appraised fair market value, especially if there is a significant difference between book and fair market value.) Total assets $171,000 Accounts payable (4%) $18,000 Notes payable (2%) 9,000 Total current liabilities 27,000 Note for equipment (9%) 25,000 Net worth (26%) 119,000 Total liabilities & net worth $171,000 Note. The financial numbers in this table were selected for ease of understanding the calculations and should not be construed as representing actual or desired practice parameters. Discounted Cash Flow Method The second method, called the Discounted Cash Flow Method (DCF), offers a valuation based on future earning capacity and recent financial performance. It takes into account gross revenue, practice operating expenses, depreciation, local area going-rate eye care professional (ECP) compensation, liabilities, and inflation. The DCF model offers the user an analysis similar to that performed by the Chief Financial Officer using this model to make investment decisions. This requires the use of a spreadsheet that projects future revenue and expenses based on recent annual changes in practice performance and expected changes in variables that could affect future outcomes. This method also allows the user to factor in anticipated changes in operations such as allocating less revenue to income or more to wages or other anticipated changes in revenue or expenses.

4 54 Practice Strategies Table 4 Steps in the Discounted Cash Flow (DCF) Method Step 1 List Revenue projected for a 5-year period with annual growth of 4.0%, using $450,000 as a base figure. Step 2 Deduct Adjusted Operating Expenses (Total Revenue Total Economic Benefit) projected for a 5-year period with annual growth of 3.0%. Step 3 Deduct Depreciation for a 5-year straight line period, using $18,000 per year as an average amount to keep current. Step 4 Deduct Replacement ECP Income with 4.0% annual increase. Step 5 Calculate Pre-tax Income, subtract Steps 2 through 4 from Step 1. Step 6 Determine Tax Due using 26% as an effective tax bracket. Step 7 Calculate Post-tax Income by subtracting Step 6 from Step 5. Step 8 Add back Depreciation. Step 9 Deduct any Liabilities due on practice assets over a 5-year period. Step 10 Add Steps 7 and 8 less 9 to yield Adjusted Net Cash Flow. Step 11 Perform Present Value calculation using discount rate. (Figure 1 indicates a practice value of $244,782.) A discount rate, which is the rate of return based on the inherent risk the business reflects, is applied to the sum of all the future cash flows to calculate what the effective value of the practice is in terms of present-day dollars. The theory behind the discounted future cash flow method is that the value of a business entity is equal to the current value of its expected future earnings. The discount rate, which accounts for the overall stability of the practice to continue producing cash flow and to retain the patient base, is determined from the buildup method previously demonstrated. Many factors affecting practice value are intangible, such as goodwill and records, and thus their worth is inherently arguable. Goodwill, in this context, is defined as the likelihood a business will continue operating under new ownership. In the past, transition to a new owner would be considered more secure the longer the seller was willing to stay on and transfer his patient loyalty to the protégé. In the new world of managed health care economics, what is the seller s rapport with his patients worth to a buyer if 85% of the patients are enrolled in various managed care vision plans that may be closed to new providers and not transferable from the selling practitioner? Why would a purchaser want to buy a practice if a good possibility exists that the majority of the plan s members will pursue other directions for vision care? This is a recent development that has become a factor for consideration when valuing practices in today s marketplace. The subjectivity associated with the valuation of major intangible factors is a chronic problem in determining practice value. The valuation of goodwill must be considered very cautiously. In most instances, it is wiser to emphasize projected revenues and expenses, which is why the discounted cash flow method has become quite popular in the last decade. Table 4 explains the steps that are performed during the discounted cash flow method. Start by listing gross revenue (line 1); subtracting total economic benefit to determine total operating costs, subtracting depreciation (line 3), and subtracting income a substitute ECP would be paid in the practice (line 4) yields pre-tax income (line 5). Multiply this number by the effective tax bracket to determine the tax due (line 6); subtract this amount from pre-tax income, yielding post-tax income (line 7). Adding back depreciation (line 8) and deducting liability and debt payments (line 9) yields net cash flow (line 10). Add each vertical column to obtain adjusted cash flow. Perform a present value calculation (as shown using the formula in Figure 1). Choose a discount rate (in this example, the business risk premium previously determined as 0.24 with a capitalization rate of 0.20). Table 5 shows the financial calculation using the sample practice parameters, whereas the current value is obtained using the calculation in Figure 1. Market Comparison Approach Revenue Multiplier Method There is a growing group of business appraisers that use seller s discretionary cash as a valuation method...in valuing small businesses, it just may be the method of the future, according to The Business Reference Guide. This method is based on a cash payback method. The discretionary cash flow or adjusted profit is the cash available to the prospective purchaser to service acquisition debt associated with the business purchase and to pay himself or herself a salary. This number is the focus of small business owners, note Leonard J. Sliwoski and Maggie Jorgenson in their article, Acquiring a Small Business: How Much Can Your Client Afford? in the October, 1996 issue of National Public Accountant. Pricing multiples for all types of businesses range from 0.4 to 5.8 times; however, the majority fall in the range of 0.75 times to 2.75 times, according to Valuing Small Businesses and Professional Practices. In the third valuation approach, the Revenue Multiplier Method, the appraiser looks at 2 areas: the practice s per- Figure 1 Present value formula expresses the supposition that the fair market value of any ongoing business is the present worth of the future cash flows in which r is the discount rate and C is the capitalization rate, which equals the discount rate less the projected annual growth. PV, present value; CF, net cash flow; r, discount rate; C, capitalization rate;, sum (sum of projected year s cash flow).

5 Practice Strategies 55 Table 5 Example of Discounted Cash Flows Method Year 1 Year 2 Year 3 Year 4 Terminal Year Revenue $450,000 $468,000 $486,720 $506,188 $526,436 Adjusted operating expenses ($292,500) ($301,275) ($310,313) ($319,623) ($329,211) Depreciation ($18,000) ($18,000) ($18,000) ($18,000) ($18,000) Substitute OD income ($105,000) ($109,200) ($113,568) ($118,111) ($122,835) Pre-tax income $34,500 $39,525 $44,839 $50,455 $56,390 Effective 26% ($8,970) ($10,276) ($11,658) ($13,118) ($14,661) Post-tax income $25,530 $29,249 $33,181 $37,337 $41,729 Add back depreciation $18,000 $18,000 $18,000 $18,000 $18,000 Liabilities (5,000) (5,000) (5,000) (5,000) (5,000) Net cash flow $38,530 $42,249 $46,181 $50,337 $54,729 formance compared with national medians and data from the sales of similar practices. Based on subjective judgment of how the practice fares in these areas, a percentage multiplier is applied to the past year s discretionary earnings or adjusted annual net earnings, giving an indication of value. The process of determining value based on making comparative judgments follows. Step 1 Obtain statistics similar to the data found in Table 6 for comparison purposes. The table is a much-abbreviated version of the Appraiser s Analysis Table (adapted from the Table 6 Practice Characteristics Past 3 Years Profit Performance Poor (below 20% of gross revenue) Average (28% to 32% of gross revenue) Superior (above 36% of gross revenue) Future Income Potential Practice will continue but make erratic low income Practice will produce stable average income Practice will produce very stable above average income Expected Growth Practice has no or little growth potential Practice will show stable average growth (4% to 6% increase) Practice will show superior growth (above 10% increase) Location and Condition of Facility Undesirable, needs complete renovation and new equipment Average locale, facility/equipment update within 10 years Excellent locale, facility/equipment update within 5 years Marketability and Desirability Barely, it will be difficult to find potential buyers Average, potential buyers will eventually be found Extremely desirable, numerous potential buyers Competitive Characteristics Extremely competitive, very likely others will open in the area Average competition, unlikely others will come Not much competition, highly unlikely others will come Total in sample is 10 points 6 items Handbook of Business Valuation) used to determine the multiple to apply to the discretionary earnings of a practice. Although each of the 6 categories in the example below has a breakdown of only 3 choices, up to 15 categories each with 8 choices could be used. The appraiser knows the range that most practices sell for relative to gross revenue and takes this into account when comparing the practice being appraised with similar ones that have sold. Step 2 Once a multiple has been calculated, it is applied to the last year s discretionary earnings or adjusted annual net earnings to determine practice value. $157, $262, points 2 points Total 10 points

6 56 Practice Strategies Determining Final Practice Value Final practice value is determined by using either an average or weighted average of the 3 appraisal methods. For the purpose of this example, we will choose a straight average. Asset Approach $318,500 Income Approach 244,782 Market Approach 262,500 Total $825,782 3 $275,260 final practice value It is worth mentioning that one dilemma inherent in valuing the intangible component of a practice is how to assess the practice growth potential. Although this is certainly a favorable intangible for the purchaser, it is still uncertain and will depend greatly on the new practitioner s efforts. Practice potential, as many sellers would hope, has yet to be realized, and although it should be taken into account, it should not add significant cost to the purchase. It can be promoted as an added incentive to buy a particular practice if the buyer believes there is untapped income that can be realized. Worth the Effort Those who enter the practice of optometry do so because they enjoy delivering eye care to patients. They do not necessarily enjoy finance or accounting, both inherent in the 3-tiered valuation process outlined here. In fact, many optometrists find such exercises tedious. Some may balk at the methodology presented here as overly complex. However, those who use this method will find that it does not take as long as might be expected and that it will, in many cases, yield a value very close to a practice sale price upon which a buyer and seller can agree. The time invested in the valuation process can be considered well spent if it helps a retiring practitioner successfully pass on to the next generation of private practice optometrists an established practice the owner spent a lifetime building. For additional information on the valuation of a practice see Assessing the Value of a Medical Practice, 2nd edition, by J. Max Reiboldt, published by the American Medical Association or Eyecare Business: Marketing & Strategy by Gary Moss, O.D., M.B.A. and Peter Shaw McMinn, O.D., published by Butterworth-Heinemann.