Earnings before interest, taxes, depreciation, and amortization (EBITDA) gets talked about exhaustively in the world of dental practice valuations. EBITDA doesn’t determine value. Math does not dictate value unless the math means something. When talking about EBITDA, the conversation is usually about COST. The value of a business often gets trivialized by taking the EBITDA, multiplying it by a number, and letting the result be the focus of negotiation. But what actually matters in an acquisition isn’t the cost, it’s the return. Return on investment is where things get emotional for a buyer. And if the buyer is writing the cheque, their opinion matters (even if it’s borrowed funds).
We’re ok with buying cars, because we need them, and we accept that they depreciate like a sinking stone. But businesses are not cars. Businesses sell because the buyer wants the profitability that comes with it. So, when it comes to buying a practice, what kind of return on investment makes sense?
In my experience the answer to that comes down to intended use. Who is the buyer? Passive investment return is ideally 8% in the investment marketplace. That doesn’t always happen, but it’s the number most investors work off. At 8%, the investment doubles in 10 years. Historically, real estate has been in this ballpark in Canada (save for recent years). But owning a practice isn’t passive. So, what’s the investment expectation for managing the practice as an owner (not associating – just the ownership part)? If we look at capitalization rates, which reflect the ROI of an investment, we get some idea of where things land. A capitalization rate of 8% on $1M would yield an $80,000 gain in year one. In dental practices, my observation is that cap rates are often 12 – 20%. This assumes that the practice is profitable beyond the dentist remuneration. Also, the cap rate requires the full investment of the purchase price to be realized. In other words, this reflects a cash purchase price. If a practice is financed at 5.20%, a cap rate of 8% would only yield 2.8% of realized earnings.
A higher cap rate reflects higher risk and lower demand. This might be a practice that is in a more remote region and harder to replace associates/ team members. Or a speciality practice. Lower cap rates reflect higher demand. More bids drive up the price and if someone out there wants a practice so badly that they can live with a cap rate of 1-2%, then so be it.
If we allow cap rates to guide our thinking instead of EBITDA, it tends to make the conversation more meaningful. If you as a buyer decide you want a return on investment of 15% to justify the purchase and the active involvement it will take for you to manage the practice, that creates a meaningful start to a negotiation. And if your counterpart wants to talk about EBITDA, all you have to do is invert the cap rate. 100 divided by your cap rate is the EBITDA multiple. So, if you want a 15% return on your acquisition, 100/15 = 6.7. A 15% cap rate = an EBITDA of 6.7. If you want a 20% return, you’re dealing with an EBITDA of 5. If you want a 12% rate of return, you’ve got an EBITDA of 8.3.
Valuation transparency creates literacy. Literacy permits meaningful negotiations that close deals. The key is starting with numbers that are based on math that matters, not emotions.
