How to Value a Veterinary Practice?

RULE OF THUMB TO VALUE A PRIVATE PRACTICE?

Many health-care professionals are familiar with frequently used rules of thumb in valuing a private practice, such as 60% - 120% of revenues or 4 - 12 times cash flow. Based on this rule of thumb, a private practice with revenue of $2mil and cash flow of $600,000 can then be worth anywhere from $1.2mil to $7.2mil. With such a wide range of results, this calculation is not useful on its own and does not give you an accurate assessment of a fair market value of your practice.

The value of any business is based on its cash flow, the risk of investment and the return of the investment to the buyer.

Rule of thumb calculation can be useful, however, as a second step to compare your value to the range, consider your marketability and analyse potential for additional value creation in your practice.

INCOME-BASED VALUATION METHODS

Most knowledgeable buyers would use an income-based valuation method, such as capitalized earnings or discounted cash-flow. These methods would deal with the specifics of your practice, rather than industry averages and thus would produce a more accurate result.

Both methods usually define income as a pre-tax normalized cash flow of your practice (also known as EBITDA, or Earnings Before Income Tax, Depreciation and Amortization).

Capitalized earnings model

Capitalized earnings model is useful for practices with predictable even growth or no significant expected growth. The most common basis of this valuation method is the practice’s prior year normalized cash flow (however, in some circumstances, average cash flow over the last few years, trailing-twelve-month cash flow or projected current year’s cash flow can be used instead). Some judgement and knowledge of the industry is involved in normalizing practice’s historic results to accurately reflect sustainable earnings of the practice. Selected cash flow is then multiplied by the capitalization multiple. The multiple would reflect expected growth rate of your practice, risk and opportunities associated with your business, clientele, location etc.

For example, practices expected to grow as a consistent high rate in desirable growing communities would justify a higher multiple. Similarly, larger (in terms of revenue and FTE doctor staff) well-managed practices with garner a higher multiple as there is less risk in transitioning the practice to the new owner than would practices that are smaller and more reliant on the owner. Judgment is involved in selecting a multiple or a range of multiples as well as sufficient familiarity with your practice’s specific circumstances. Be sure to select a valuator, who will be diligent in learnings the particulars of your practice and not make quick generalizations.

Discounted cash-flow model

Discounted cash-flow model involves projecting 3-5 years of future cash flows (EBITDA) and then calculating the net present value of that income. The projected cash flows are based on a reasonable growth rate of revenue and associated practice costs each year, and then discounted by the assumed cost of capital plus a risk premium. It is inherently more difficult to predict future results and the discount rate used to calculate the net present value will reflect this additional risk.

For practices with even predictable growth, both methods when applied consistently, will produce the same result. Thus, there is rarely much benefit in using a discounted cash-flow model to determine fair value of an established practice. However, newer practices, which may initially grow at a higher rate than industry can benefit from the additional insight of using projected cash flows. Discounted cash flow method might also be more useful if the business is expected to undergo significant change post-sale, for example converting a larger general veterinary practice to 24hs emergency hospital.

KNOWLEDGE IS POWER

It is often very valuable to look at your practice through the lens of a potential sale even if you are not planning to sell in the near future. This process will highlight value creation opportunities in your business as well as risks that can be addressed or mitigated to strengthen your business.

It is also valuable to remember that it is normalized sustainable cash flow that is the driver of your practice’s value, not net income as reported by your accountant. There are many differences that could exit between accounting income and normalized cash flow. Here are just a few of them:

• Personal and discretionary expenses (e.g. donation, travel, meals, automotive etc.) will reduce your accounting net income but will generally not impact your normalized cash flow. Similarly, income not expected to be earned by the new owner (e.g. interest income of excess cash and GIC’s or rental revenue from property owned in the business) will not be included in the calculation of the normalized cash flow.  

• One-time expenditures (e.g. flood repair costs) and one-time income (e.g. Covid government assistance) will also be excluded from normalized cash flow.

• Capital expenses will also be normalized whether your account has repotted then as capital additions or slimily expensed the whole amount in the year of purchase.

• Equally as important, your cash flow may be adjusted to reflect more sustainable earrings. Here are some examples:

• Your salary as an owner almost always reflects your tax planning objectives and your lifestyle requirements as opposed to the fair value of your effort. It may be that you did not take any salary from the business, or it may be that you all or some of the excess cash was removed as salary to the owner and/or family members. In order to understand the true profitability of your business, it is important to make a fair assessment of your wage as well as the wage of any family members involved in running your practice. Is it helpful to ask yourself, how much would I require as a salary should I sell my business and continue working for a new purchaser?

• This assessment should also take into consideration your production and your hours of work. That is, if it would take two professionals to replace your production or your hours of work, the average wages of two doctors will be included in the sustainable cash flow rather than one.

• Any sources of revenue that are unique to you and will not transfer to the new purchaser should also be considered. This might be the case with some of the alternative modalities and specialized procedures. If these sources of revenues are not sustainable by the practice after your departure, they should be excluded.

• Lastly, the cost of goods sold and the staff wages (as a percentage of revenue) should be compared to the industry and scrutinized. These costs provide an insight into the management philosophy of the practice and can be difficult to change. Therefore, these two cost categories provide the greatest opportunity to the owner to enhance the value of the practice through effective practice management ahead of the sale.

• Going though a process of valuing a practice can be very valuable to give you not only an indication of what your practice is worth today and how it compares to its peers, but also an insight into its potential.