How to Determine What a Dental Practice Is Really Worth
Price is what you pay, value is what you get. — Warren Buffett
A cynic knows the price of everything and the value of nothing. — Oscar Wilde
You should always know the difference between value and price. The price of something is just a number that a buyer and seller agree on in the marketplace — the intersection of supply and demand for something at a moment in time. For example, the value of gold never really changes, but the price moves all over the place. It is important that you see the value in the dental practice, and then determine what price works for you.
Your goal is to understand the practice well enough to put your own value on it in dollar terms. Then you can compare your number to the asking price and determine where there is a significant difference between price and value. You want to make sure you do not pay more than the value you place on the practice.
A gold mine would be a practice for which your calculated number is well above the asking price. It gets interesting, and exciting, when you see much more value than the asking price, and when you would be willing to pay much more than the seller is asking but don’t have to.
The primary calculation that determines a dental practice’s value for you is cash flow, or EBITDA. There are many other subjective things to consider, such as being in a location that you love, or merging with another practice close to your present location — but always calculate the EBITDA first to mathematically determine the value. The EBITDA is the amount of money left over after compensating yourself at least 30 percent of your personal production and after paying all the other expenses of the practice. This is the amount of money available to pay the loan for your practice purchase.
It’s always good to become familiar with the methods appraisers use to value a practice — asset, market, or income approaches (covered in Part 2). The perfect Ted Williams strike is a practice that warrants a lower market-appraised value, but a much higher value from the income approach. Maybe you grew up, or still have family, in an area that isn’t on everyone’s list of great places to live. You could receive a lot of value from a practice listed at a lower price because its market value trumps the present value based on the income approach.
Your Back-of-the-Envelope Calculation
When doing a back-of-the-envelope calculation, forget about any inflation or growth — this builds in a slightly bigger margin of safety for you, the buyer. The discount rate and the capitalization rate are used the same way to calculate our price for the target dental practice:
price = EBITDA / your cap rate
Or, looking at it another way, calculate the cap rate at the current asking price:
proposed cap rate = current EBITDA / asking price
Remember, this EBITDA number should already have your compensation at 30 percent of your anticipated production subtracted out. EBITDA is gross collections – (all the practice overhead + your 30 percent compensation for dentistry produced).
EBITDA is the amount of money available for debt service, because you have already paid yourself for your dentistry at 30 percent of your anticipated production. Divide this number by twelve to figure out how much is available each month to service the loan. Loan payments should be calculated over seven years at the current competitive interest rate.
Again, at a minimum, a buyer should earn 30 percent of his or her personal production while paying off the note within seven years.
Action step.
Look at the gross collections of the practice and subtract out the hygiene portion. If there are associate dentists at the practice, subtract out their collections as well:
gross collections – (hygiene collections + associate collections) = your anticipated collections on your production
Multiply that answer by 30 percent — that is your compensation for the general dentistry you personally do:
your production × 30 percent = your compensation for your personal production
Add your compensation to the overhead (all the expenses of the practice):
(your compensation) + (practice expenses) = minimum amount of money needed to operate the practice
Subtract that number from the practice’s gross income:
(practice gross income) – (minimum amount needed to operate) = cash flow available for debt service
Divide by twelve to get the excess earnings per month — the maximum amount available for your loan payment. Assume a seven-year note (eighty-four payments), plug in the available interest rate from the bank, and use that as the loan-payment amount to determine the maximum value of the practice from a cash-flow perspective.
Remember, this formula is intentionally simplified — a venture capitalist would use the calculated cost of capital rather than the interest rate alone: the return on investment he or she must earn to make financing a certain practice a worthy investment rather than parking money elsewhere.
The key is to calculate the value using cash flow (excess earnings or EBITDA). In some cases, you might be willing to pay more than this number — you might love the location, or there might be other factors making it the perfect strike for you. Just know that in those cases, you are not buying based on the income approach, and you will initially be making less than 30 percent of your personal production.
Marvin Gardens for the Price of Baltic Avenue!
Sometimes the asking price is lower than the cash flow would dictate — these could be diamonds in the rough, practices where other market factors are lowering demand and keeping prices low. For example, I watched a friend buy a practice that was significantly undervalued based on the income approach. It grossed $700,000 in rural North Carolina, and he grew it to $1,500,000 within two years. It was a true value investment! Look at these situations closely; they could be home runs.
Practice Example
When analyzing practice cash flow, always determine what your earnings will be as a percentage of your personal production. Let’s look at a target practice presently collecting $600,000, of which $150,000 is produced by the hygiene department. If everything remained the same, the purchasing dentist could anticipate producing around $450,000 ($600,000 – $150,000).
Compensate yourself 30 percent of your personal production: $450,000 × 30% = $135,000. (If you were an associate, a good compensation rate would be 30 percent of your collections, usually with a deduction for lab expenses — but let’s skip that deduction here for a bigger margin of safety.)
Assume the practice overhead is somewhat high, say 65 percent: $600,000 × 65% = $390,000 in overhead expenses. Add the overhead to your compensation: $390,000 + $135,000 = $525,000.
Subtract that from annual gross collections: $600,000 – $525,000 = $75,000. This is the excess earnings, or EBITDA. Divide by twelve: $75,000 / 12 = $6,250 per month available for debt service.
At a 7 percent interest rate over seven years (eighty-four payments), you could afford to pay about $415,000 for the practice — roughly 69 percent of gross collections.
Just for fun, what cap rate does that offer imply?
cap rate = EBITDA / price = $75,000 / $415,000 = 18%
An 18 percent cap rate is low for the dental industry, where cap rates typically range from 20 to 35 percent (remember, our EBITDA here is understated since we assumed no revenue growth).
What if you required a 22 percent rate of return to cover your risk? 22% = $75,000 / price → your offer would be $340,909, or 57 percent of gross. The broker and seller might say no, but you’d be making an offer based on real data.
Your cap rate changes based on the perceived risk of each individual practice. You might lower your required cap rate because you love the practice and location — the surfer wanting a practice on the California coast is probably willing to pay a higher price (accept a lower cap rate) because that practice has greater subjective value to them.
A higher cap rate than the one calculated for your maximum loan payment means more money left over after paying the debt — you’ll earn more than 30 percent of your personal production. A lower cap rate means you earn less than 30 percent, but it might be worth it for the better surf! If the cap rate is too low, the bank loaning the money will say no — it’s too risky. Understanding this concept is the most important thing you will learn from this series! If you can calculate a back-of-the-envelope expense analysis of any practice, you have almost all the information you need to ask the broker or seller the right questions and find the most valuable practice for you at the right price.
More Worked Examples
Scenario 1: One dentist and one hygienist
- Gross income of the entire practice: $600,000
- Dentist (seller) production at 80%: $480,000
- Hygienist production at 20%: $120,000
- Overhead: 70%
Calculate the value if you require 30 percent of your personal production as reasonable income:
- Overhead: .70 × $600,000 = $420,000
- Your compensation: $480,000 × .30 = $144,000
- Overhead + compensation: $420,000 + $144,000 = $564,000
- Earnings available for debt service: $600,000 – $564,000 = $36,000/year, or $3,000/month
- At 7% over seven years: you’d pay only $200,000 for this practice — 33 percent of gross revenue
This practice doesn’t offer good cash flow because overhead is too high — usually a large occupancy cost, overbuilt space, or understaffing/overwork because fees are too low (sometimes due to Medicaid or capitation plans). If you could raise fees 10 percent without losing patients, that adds $60,000 directly to the bottom line:
- New gross income: $660,000
- Overhead stays at $420,000 (now 64% of the new, higher gross)
- Your production at new fees: $528,000; your compensation: .30 × $528,000 = $158,400
- Income available for debt service: $660,000 – ($420,000 + $158,400) = $81,600/year, or $6,800/month
- At 7% over seven years: maximum practice value rises to $450,000 — 68 percent of gross
A much better scenario! Make sure you understand why the overhead is high, because you might find a diamond in the rough.
Scenario 2: One dentist and one hygienist
Gross income: $700,000
Hygienist production: 30%
Dentist production: 70%
Overhead: 70%
Dentist requires 30% of general dentistry: .70 × $700,000 = $490,000 → $490,000 × .30 = $147,000
Overhead: .70 × $700,000 = $490,000
Money needed for operation: $147,000 + $490,000 = $637,000
Money available for debt service: $700,000 – $637,000 = $63,000/year, or $5,250/month
At 7% over seven years: maximum practice value = $350,000
Practice Scenario: multi-provider practice
Gross income: $1,500,000
Hygiene production (30%): $450,000
Owner dentist production: $650,000
Associate dentist production: $400,000
Overhead before paying owner and associate: 62%
Owner compensation: 30% × $650,000 = $195,000
Associate compensation: 30% × $400,000 = $120,000
Overhead: 62% × $1,500,000 = $930,000
EBITDA: $1,500,000 – ($195,000 + $120,000 + $930,000) = $255,000, or $21,250/month available for debt service
At 7% over seven years: a dentist could theoretically pay $1,400,000 (93 percent of revenues) — though the market approach would likely prevent paying that much, meaning the owner would take home well above 30 percent of personal production.
If the practice sold for $1,400,000, the (simplified) cap rate would be $255,000 / $1,400,000 = 18 percent. Requiring a bigger margin of safety at a 30 percent cap rate instead: $255,000 / price = 30% → offer = $850,000, or 57 percent of gross.
If the seller accepted $850,000 (seven years at 7%), the monthly payment would be $12,829, leaving $8,421/month ($101,052/year) in additional income after debt service. This owner dentist would earn $195,000 + $101,052 = $296,052 while producing $650,000 of the practice gross — that’s 46 percent of personal production after paying the debt.
Next up: in Part 5, a step-by-step roadmap — the twelve concrete steps from “thinking about it” to owning the keys.