There are two main components that create practice value: profit and risk/desirability.
Most valuations are done with the goal of arriving at Fair Market Value, the value of the practice if put on the open market for the average buyer.
The basis of value is profit. ALL high value practices have high profit, but not all high profit practices have high value. This is due to the intangible elements (risk/desirability) like location, quality of staff and facility, services offered, etc.
True profit is figured by converting the tax-based accounting documents to management-based. Profit is NOT the bottom-line number on the tax return. Since tax returns are generally designed to minimize taxes, they typically do not reflect the true profit of the business. The true profit is the amount of money left over after subtracting from gross revenue all the normal operating costs (owner’s compensation and rent ARE normal operating costs and NOT part of profit).
This remaining amount (profit) is capitalized. Capitalization of profit is the amount of return the average investor expects to receive on an investment annually, with the investment being the value of the practice. A capitalization rate is also the expected rate of return or ROI. A less favorable, more risky practice with a high rate (ex. 35%) means you pay less and as a result get a better ROI than if that same practice had a lower capitalization rate (lower expected ROI). Many factors should be considered in determining the capitalization rate and this is where the “art” of valuation enters in. Some factors considered when arriving at an appropriate capitalization rate include practice growth, geographical location, employee tenure and skill, seller transition period, practice style (boutique vs high-volume/low-cost), competition, etc. All of these things are elements of risk/desirability that have an influence on value, and, yet, don’t show up on the financial statements. If the risk of maintaining the current level of profit is greater in one practice than another, even though the profit is the same right now, its value will likely be lower.
How does a multiple relate to the capitalization rate? The multiple is the inverse of the capitalization rate. A less favorable practice will have higher a capitalization rate and a lower multiple and vice versa.
We have been discussing fair market value and capitalization rates, but how do corporate offers compare to this? Corporate consolidators do not value practices on fair market value but use investment value instead. Investment Value is defined as “the value to a particular investor based on individual investment requirements and expectations”. Their capitalization rates are much lower than a fair market valuation because they are considering their investment requirements, expectations, and the synergy they will have between their corporation and the acquired practice.
Practice valuation, much like veterinary medicine, is a science and an art. If you want to learn more about practice valuation, join us on our webinar, April 17th at 4pm MST or contact Dr Kate Owens directly at [email protected] or (303) 729-0870.
This is a paid sponsored content article from Simmons Veterinary Practice Scales & Appraisals.
