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Hot Topic: How Much Is an Optometry Practice Really Worth?

How the price of a practice can be determined in today's business world

By: Greg Stockbridge, OD, MBA, and
Eyecare Business September 1, 2009

Hot Topic: How Much Is an Optometry Practice Really Worth?

How the price of a practice can be determined in today's business world

By Greg Stockbridge, OD, MBA, and Allan Barker, OD

It gets confusing. How much is an optometry practice really worth? We see all types of formulas that experts use when evaluating the worth of a practice. Who knows which one to believe?

Have you ever though about how large businesses evaluate the worth of other businesses? Historical attempts to come to grips with the worth of an optometry practice include the Hubler Formula in 1987, the Bennett Formula in 1993, and the 2005 Gilbert-Morgan Formula. All are different.

In this article, we are going to simplify just how the price of an entity can be determined in the business world and you may see that the formulas often used to value Optometric practices are impractical.

The basic concept behind a business evaluation is NOT how much equipment a practice has or how much goodwill it possesses. It's strictly about how much cash flow is left over at the end of the day.

The business evaluation process that we will be describing is called NPV or Net Present Value. This process allows one to make comparable business investments by determining the leftover cash flow for a set number of years and adding up all the totals to come up with the true monetary value of a business.

LESSON PLAN

There are several important conclusions to gain from this article:

  1. In no way are we saying that a $1M practice is worth $X. We are saying that, using the assumptions we have put in place, the practice is worth X based on net present value formulary.
  2. At the end of the day, the value of a practice should be determined by the amount of cash left over after factoring in your own own employed salary and discounting back cash flows at a rate equivalent to alternative investments. There are many assumptions and predictions that we have to make when adequately using the NPV methodology. But, when used appropriately, it is a powerful tool that allows you to make educated savvy investments.
  3. The primary weakness in most current practice worth formulas is their inability to adequately differentiate in a recognized business criteria model the difference in values between various size practices. One size does not fit all. If, for example, we say a practice is worth an arbitrary value of 75 percent of collected revenue, that means a $200,000 practice is worth $150,000 and a $1,000,000 practice is worth $750,000 and so forth. Such a linear relationship is simple and completely unrealistic in the current business environment.
    Under the Net Present Value methodology, the smaller revenue practice is at a distinct disadvantage and may be grossly overvalued under old outdated methods of valuation. For example, in our model the $2M practice is worth approximately 82 percent of revenue, the $1M is 73 percent, the $500K is 54 percent, and the $250K practice is about 27 percent of revenue.
    Sadly, this explains a current phenomenon. The smaller practice's main value becomes what the doctor can take home each year rather than what can be expected from a sale. This explains why many doctors are being forced to close their practices as there are no buyers.
    If a doctor has a smaller practice, according to the NPV formula, he or she needs to either grow the practice, possibly by taking in an associate who could become a potential buyer, or face the fact that there very well may not be a buyer when it's time to retire.
  4. Subjective factors over and above NPV assumptions are not totally irrelevant, but are only relevant when the effects are major. An example would be a lease about to expire which is not being renewed by the landlord and where there are no acceptable moving sites available.
    Another example would be a practice purchase where the doctor has been convicted of a felony and is forced to sell his practice. These subjective factors are major and decrease the practice's true value.
  5. The NPV is a powerful, but complicated tool. To come up with a proper price for your practice, you need to utilize proper advice rather than simple outdated formulas. If we rely on some of the formulas used today to value practices, we may ultimately pay for or sell an optometry practice for the incorrect price.

PLAN IN ACTION

In the tables that accompany this article, we analyzed the value of hypothetical practices ranging from $2 million gross revenue down to $250,000. The first table outlines our assumptions. The rest illustrate those assumptions that we implemented into the tables. EB

Greg Stockbridge, OD, MBA, graduated from New England College of Optometry in 2000 and received his MBA from Duke University in 2007. Allan Barker, OD, is president of Eyecarecenter, OD, PA, and serves as presidentelect of the North Carolina State Optometric Society. Both are practicing optometrists.

TABLE 1: ASSUMPTIONS BY PRACTICE SIZE
Assumptions $2 million $1 Million $500,000 $250,000
Tax rate 35% 35% 35% 35%
Discount rate 6% 6% 6% 6%
Inflation rate 3% 3% 3% 3%
Growth rate of Practice 2% 5% 7% 12%

TABLE 2: $2 Million Dollar Practice
Year 1 3 5 6
Revenues 2,000,000 2,142,000 2,249,100 2,408,786
(−) Cost 1,600,000 1,697,440 1,748,363 1,854,839
(−) Depreciation 100,000 100,000 100,000 100,000
Cash flow CEBIT) 300,000 344,560 400,737 453,948
Taxes 105,000 120,596 140,258 158,882
After-tax profits 195,000 223,964 260,479 295,066
(+) Depreciation 100,000 100,000 100,000 100,000
(−) Change in Working Capital 4,000 4,000 4,000 4,000
(−) Capital expenditures 10,000 0 0 0
Project Cash flow 281,000 319,964 356,479 391,066
Unlevered Discounted Cash Flow 265,094 268,648 282,365 275,686
Total of all Discounted Cash Flows $1,641,681
NPV = Amount Paid − Total of all Discounted Cash Flows

TABLE 3: $1 Million Practice
Year 1 3 5 6
Revenues 1,000,000 1,102,500 1,215,506 1,276,282
(−) Cost 850,000 901,765 956,682 985,383
(−) Depreciation 50,000 50,000 50,000 50,000
Cash flow (EBIT) 124,500 150,735 208,824 240,899
Taxes 35,000 52,757 73,088 84,315
After-tax profits 80,925 97,978 135,735 156,584
(+) Depreciation 50,000 50,000 50,000 50,000
(−) Change in Working Capital 4,000 4,000 4,000 4,000
(−) Capital expenditures 10,000 0 0 0
Project Cash flow 101,000 143,978 181,735 202,584
Unlevered Discounted Cash Flow 95,283 120,886 135,803 142,814
Total of all Discounted Cash Flows $736,246
NPV = Amount Paid − Total of all Discounted Cash Flows

TABLE 4: $500,000 Practice
Year 1 3 5 6
Revenues 500,000 572,450 655,398 701,276
(−) Cost 475,000 503,928 534,617 550,655
(−) Depreciation 25,000 25,000 25,000 25,000
Cash flow (EBIT) 0 43,523 95,781 125,621
Taxes 0 15,233 33,523 43,967
After-tax profits 0 28,290 62,258 81,653
(+) Depreciation 25,000 25,000 25,000 25,000
(−) Change in Working Capital 4,000 4,000 4,000 4,000
(−) Capital expenditures 10,000 0 0 0
Project Cash flow 11,000 49,290 83,258 102,653
Unlevered Discounted Cash Flow 30,694 51,890 62,215 72,367
Total of all Discounted Cash Flows $268,927
NPV = Amount Paid − Total of all Discounted Cash Flows

TABLE 5: $250,000 Practice
Year 1 3 5 6
Revenues 250,000 313,600 351,232 440,585
(−) Cost 287,500 305,009 314,159 333,291
(−) Depreciation 12,500 12,500 12,500 12,500
Cash flow (EBIT) −50,000 −3,909 24,573 94,794
Taxes −17,500 −1,368 8,601 33,178
After-tax profits −32,500 −2,541 15,972 61,616
(+) Depreciation 12,500 12,500 12,500 12,500
(−) Change in Working Capital 4,000 4,000 4,000 4,000
(−) Capital expenditures 10,000 0 0 0
Project Cash flow −34,000 5,959 24,472 70,116
Unlevered Discounted Cash Flow 32,075 5,004 19,384 49,429
Total of all Discounted Cash Flows $66,929
NPV = Amount Paid − Total of all Discounted Cash Flows

SUMMARY
Yearly Revenue Total Discounted Cash Flows
$2 Million Practice $1,641,681
$1 Million Practice 736,246
$500,000 Practice 268,927
$250,000 Practice 66,929

Fundamental Assumptions
Before determining the NPV of a practice, it's important to understand some basic financial concepts and some fundamental assumptions that you will need to make when using this evaluation process.

1 Cash flows: This is just the difference between dollars received and dollars paid out. It is important to not get this confused with accounting profits. Accountants can come up with creative ways to reduce taxable income and it is hard to look at a tax return to adequately evaluate the true amount of net profit. For example, accrual accounting will show profits before patients actually get around to paying the bills. Secondly, accountants will sort cash flows into current expenses which are deducted from profits during the current year, and capital expenses which are depreciated over time. As a result, profits will include some cash flows and exclude others—and that is why looking at accounting statements can get confusing. The NPV method simplifies things by looking at dollars received versus dollars paid out.

2 Time value of money: What this means is that the value of a dollar today is not the same as the value of the dollar tomorrow because of inflation and rates of returns. In other words, if you invested a dollar today at 5 percent interest rate, it would be worth $1.05 next year. The reverse is also true; $1.05 next year is only worth $1 today given an interest rate of 5 percent. This is an extremely important concept to understand because you will see in our examples we discount future cash flows back to a present value to determine the NPV.

3 Opportunity cost and discount rate: It is described as the next best choice that one gives up when making a business decision. For example, maybe you are torn between investing your money into the foreclosure real estate market or in the purchase of a practice. You may consider them both good choices, but you decide that owning a practice will provide you with a slightly higher return on your investment. This means that you have given up the opportunity to purchase foreclosures because you decided to invest in your practice. This concept is important because when we discount future cash flows back to present value, we will use a rate equal to a rate of return of an alternative investment rate. For simplicity's sake, in today's economy, it is fair to pick a rate of 6 percent. Historically, the rate used was closer to 10 percent—with the stock market's return on investment often cited as the landmark.

4 Inflation rate and employees' salaries: We all know that inflation tends to drive up prices year after year. Therefore, costs will tend to go up every year. Historically, we have seen an average inflation rate of 3 percent and that must be accounted. On average salaries have risen about 4 percent per year.

5 Growth rate: Through many years of experience of purchasing practices, we can say that we usually see no growth in patient revenue the first year. Therefore, we should account for this the first year and then estimate an annual growth rate that is reasonable for the size of the practice as well as its competing environment. Our examples shown here used a growth rate of 12 percent for the $250K practice, 7 percent for the $500K practice, 5 percent for the $1M practice, and 2 percent for the $2M practice. Our assumption is that it is easier to produce a larger percentage growth in a smaller practice as opposed to a larger practice.

6 Capital expenses: Rarely does anyone purchase a practice and is 100 percent satisfied with everything. You may not like the computer software or even the color of the walls. This expense is recognized the year that it occurs under the capital expense category.

7 Depreciation: This is a non-cash expense. Depreciation is important because it reduces the taxable income. In the calculation we subtract depreciation from the taxable income, and then add it back after we figure out the post-tax profit. We do this because it is actually income that was generated and should be recognized although it shows up as paper loss and is not a real loss of capital. Other considerations are the alternative minimum tax, the different depreciation cycle of various assets, and the fact that the larger the practice, the greater its depreciation amount. For simplicity sake we elected to use a consistent rate of 5 percent of the first year's gross revenue. The true amount needs to be determined by an accountant and is based on the purchase, not the current depreciation that exists prior to the purchase.

8 Number of years to analyze cash flows: Ask yourself the question: “What is a reasonable number of years that I am willing to risk my money on the investment of a practice?” Things could happen in life that limit your ability to practice. A practice purchase should not be considered as a 20- or 30-year investment. Most of us would be willing to invest in a practice that could be paid off in approximately six years, and we use this number when calculating NPV. Though there is an argument for five years, we have used the higher value of six years to compensate for the negligible number assigned for a terminal value (see #12).

9 Making investment decisions: It is important when using NPV to not take into consideration debt proceeds from the required investment, nor should you recognize interest and principal payments as cash outflows. When determining NPV, the project is analyzed as if it were all equity financed or unlevered. Keep in mind that investment decisions are different than financing decisions.

10 Working capital: Working capital summarizes the net investment in short term assets associated with running the business. Working capital warrants its own line in the NPV calculation. Simply stated, working capital is the difference between current assets and current liabilities. Current assets can include inventory and accounts receivable. Current liabilities can include accounts payable. Thus Working Capital = Inventory + Accounts Receivable − Accounts Payable. An increase in working capital means a business has either increased current assets, such as cash or other assets, or decreased current liabilities. A decrease in working capital indicates the reverse.

11 Your Salary: Optometrists often don't consider their expected reduction in salary when first purchasing a practice as an added expense to the practice. In other words, if you pay $250,000 for a practice, and you take a pay cut of $50,000 a year for five years, then you have actually invested $500,000 in your practice and not $250,000. Therefore, when you evaluate your future cost of running the business, you have to add in the normal salary that you would have earned if you did not decided to purchase the practice.

12 Terminal value: In many transactions, the participants will use a terminal value. That is the value of the purchase when it is sold and discounted back to today's present value. This is a very difficult thing to quantify. Generally, when a doctor purchases another doctor's practice, we are looking at a transaction where the benefit is in terms of a long-term income stream as opposed to a potential short sale. We have, therefore, not assigned a terminal value, though we do recognize that in larger sales, such as the purchase of a 50-location chain by a publicly traded entity, terminal value would increase the value of the transaction.

13 Cost: Cost includes an average doctor's salary. This cost decreases in percentage relative to the revenue as the practice increases in size.

14 NPV: This is the difference between the price paid for the practice and the total for all discounted cash flows (NPV = Amount Paid − Total of Discounted Cash Flows). In other words, if you pay more than the total of all discounted cash flows, then the NPV of the practice will be negative. This would indicate that the investment is actually returning less than the discount rate.

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