Purchase and Sale - Eight Post

EW: The conceptual framework for valuation of a practice has been examined in the previous article. We now look at practical approaches to determining value. They include: Net asset value, comparable market, and approaches based on earnings.

NET ASSET VALUE

This approach is used where the practice has wound down and there is no value beyond selling the equipment and other tangible assets. It is also used where the goodwill of the practice is of a personal nature, and therefore, not transferable or saleable. This personal goodwill represents the personal skills, techniques, experience and contacts of the individual chiropractor. Lastly, it is used in the valuation of a successful practice, going-concern, where the tangible assets are determined and valued separately from the goodwill.

Net asset value can be determined in a few ways. The simplistic approach would be to value the tangible assets (eg. Equipment, furniture, etc.) at their depreciated book value on the financial statements. This may be applicable where their value in use closely approximates book value. Often, adjustments have to be made to book value, either increasing or decreasing the value. An example of an adjustment would be for land and building, where they are included in the sale of the practice. They would have to be adjusted to reflect outside appraisal. Another type of adjustment may be to reflect costs of liquidation where a practice may be closing or be subject to a bankruptcy situation. In that situation, a purchaser could be acquiring someone=s used equipment at bargain prices.

COMPARABLE MARKET

This approach determines the value by comparing it to other practices that have been sold close to the date of valuation. Most of us are familiar with this approach, especially as it pertains to real estate. Unlike real estate, however, transactions involving chiropractors tend to be private and there are not many comparable practices for sale at any given time. Many times, practitioners will make reference to a practice which they have heard has been sold at a given price and suggest that they be entitled to at least the same since their practices are similar. Since there are a multitude of factors which affect the value (see previous articles), NO TWO PRACTICES ARE ALIKE!

Clearly, to be useful as the primary valuation approach, one needs a large sample of practices sold with all relevant factors addressed. Because of its inherent drawbacks, this approach is most often used as a reality check with which to assess a value using another method.

EARNINGS BASED APPROACHES

In all cases, earnings based approaches assume the continuation of the practice after its sale known as a going concern assumption. The purpose is to determine a price which will provide to the purchaser a return on their investment at a rate of return that is acceptable to them, given the risk inherent in the practice. To many this may appear odd, talking about a practice as if it were, say, an investment in stocks or mutual funds. However, one must use the same theoretical approach to purchasing this type of business or any other. That return on investment, as described in the previous article, is the expected cash flow that the practice is expected to produce in the future. Expected cash flow is most often represented by maintainable earnings. In other words, what level of revenue less expenses can be expected to occur in the future based on the existing practice.

Capitalization of Maintainable Earnings

In its most simplistic form, this method looks at historical profits over a period of years and adjusts those profits for unusual items. Those items could include removing salaries to family members, eliminating revenues from revenue sources which will not continue in the future and adjusting for conditions which will change with the sale of the practice. The profits would typically be averaged to come up with a figure for maintainable earnings. However, to use previous years profits, or use an average only apply if the historical profits are an indication of the future. A practice which is on the downswing or is suddenly incurring excessive expenses would not be assessed based on distant history. Similarly, a practice which is experiencing significant growth should not be penalized by sticking to outdated numbers. In those cases, the more recent profits are often an indication of maintainable earnings and would be used.

Once a maintainable earnings amount is established, it is then necessary to capitalize those earnings to determine a value. This process involves assessing the risk inherent with achieving the level of earnings and deriving a capitalization rate. In previous articles, we have listed many of the factors affecting risk. The capitalization rate is more often referred to as a multiple. Therefore, the lower the risk, the higher the multiple. Multiples can vary from 2 times to five times earnings depending on the risk and whether a salary for the practitioner has been assumed in the expenses. There are a number of variations of this method. Even so, it is still the most comprehensive approach because it encompasses the revenues and the expenses, as well as the assets.

Maintainable Fee Revenue

This popular method, in its most simplistic form, looks at historical revenues over a period of years and capitalizes an average at a rate which reflects risk in order to determine goodwill. Similar to the earnings method, revenue should be adjusted for non-recurring income and, often ignore historical revenue in favour of more recent relevant data, particularly where there have been recent changes in the practice. The capitalization rate which considers all the risk factors is calculated by percentage. The lower the risk, the higher the percentage. Utilizing this method, a value for a chiropractic practice could vary from 20% to 70% of annual maintainable revenue plus tangible asset value.

This method suggests that revenue is the key determinant of cash flow. It further assumes that there exists a constant relationship between revenue and that cash flow. Because of its simplicity, the maintainable revenue approach has become a "rule of thumb" for the valuation of many professional practices, including chiropractors. Its simplicity is also its weakness, because it ignores the fact that some practices may pay higher than average rent, or be more efficient with their overhead. Some may have associates to whom they pay a portion of the fees billed. Because of these deficiencies, this method should be used with caution and can be used as a reality check with a valuation based on earnings.