What's it Worth? Optometry Practice Valuations
By Practice Growth April 16, 2021
Whether selling or buying an optometry practice, the valuation of the business is the central component of the sales negotiation. A valuation is a dollar number calculated to reflect the worth of a business, and it serves to set a total price in a sale. While there is no best method to determine an optometry practice’s value, there are several methods to choose from, each with a unique lens to view the current and future state of the business.
Revenue Stream Method
The revenue stream method of valuing a practice is perhaps the simplest. This seeming simplicity can be deceiving, however, if there are a lot of outside factors that make the practice either significantly more or less valuable than paper reflects. These factors will be discussed in greater detail later, but the business location is an example that may work to either increase or decrease the total value of a practice.
Simply put, calculate a percentage of the practice’s gross revenue, or all of the income before expenses. The percentage may fall between 40% and 70% of the gross revenue in the prior fiscal year. Clearly, there is a lot of room for error. An optometry practice with $500,000 gross revenue in the previous year could be valued between $200,000 and $350,000.
If using this method to start negotiations on a practice sale, be sure you can justify the percentage of gross revenue. For instance, if you select 65% as the percentage rate for the same business with $500,000 gross revenue, the calculation is: $500,000 x .65 = $325,000. The justification of selecting a percentage rate might include a prime location, contracts resulting in low cost of goods, and the inclusion of the most up-to-date equipment in the sale.
Capitalization of Earnings Method
The capitalization of earnings method is the most frequently used means to arrive at a valuation, but it is not as straightforward as the revenue stream method. It considers more factors that influence value than the revenue stream, adopting a more income-based approach and attempting to project income of the business in future cycles. Two things are needed to determine value using the capitalization of earnings method – net present value (NPV) and capitalization rate.
Net present value is determined through a relatively complex equation that takes the prior year’s adjusted earnings and averages those with several years’ projected earnings. That helps to reflect income trends, and adjustments can also be made to compare NPV against the projected rate of return of an alternative investment. Several calculators are available online, or an accountant can assist in determining this number.
The capitalization rate projects how much can be made on a particular investment over the course of one year, which is calculated as: net operating income / operating expenses. Bear in mind that is a pre-tax number. With NPV and the capitalization rate in hand, the equation for valuation using capitalization of earnings is: NPV / capitalization rate.
Net Plus Assets Method
When the physical assets of an optometry practice need to take center stage in a valuation, the net plus assets method is advisable. Provided the depreciation schedules of the business are on hand, this is a relatively straightforward calculation using the average adjusted net and the practice’s physical asset value. Incidentally, optometry practices arrive at this adjusted net a little differently than most businesses by including the personal expenses that are run through the business by the practice’s owner. Essentially, an optometry adjusted net subtracts operational expenses, depreciation, and owner expenses from the total revenues.
Physical asset value includes the practice’s equipment, furnishings, inventory, and leaseholder improvements. These are usually reflected on the depreciation schedule, but recent additions may have to be added in to more accurately reflect the business’ current worth. With figures for both optometry adjusted net and physical asset value, simply add the two together for a net plus assets valuation.
Debt Service Model Method
A less utilized method for valuation is the debt service model. This is most appropriate when a considerable amount of the practice’s property and other physical assets are financed. This valuation method focuses on the ability of the practice to repay those financial obligations with its current revenue levels over a period of ten years.
You will need to know the prior year’s adjusted earnings as well as the amount of interest that will be paid over the coming ten years. The interest can be taken from the amortization schedules of each financing agreement and added together. Using the debt service model, the valuation is calculated using the following equation: (annual adjusted earnings x 10) – (ten years of interest on financing). If financing is expected to last longer or shorter, this can be adjusted by respectively changing the number of years in the equation.
Other Influences on Valuation
Performing a practice valuation is more subjective than many think, which is why it is vital to make adjustments to reflect other influences on the worth of the business. Some common factors that ultimately increase or decrease an optometry practice’s value are:
- Competition levels
- Completeness of patient records
- Employee retention
- Established fee structure
- Future equipment needs
- Lease terms and transferability
- Neighborhood demographics
- New and former patient ratio
- Parking and accessibility
- Renovation needs
- Scope of practice
Without adjusting the process for any factor that is significantly better or worse than the average in the industry or geographic area, the final valuation number can be greatly skewed.
Final Thoughts for a Good Valuation
Both optometry practice buyers and sellers should be transparent about needs and open to negotiation. After all, the sale won’t happen unless both parties can benefit. This is best achieved by viewing the valuation as a process rather than a single event. Sellers should cultivate awareness of everything that constitutes an asset as well as those factors that detract from the practice’s worth. Buyers must be sure they have the resources and support to close the deal and be able to operate with a 5% - 10% dip in revenues the first year after a change in ownership. With everything out in the open, both parties can arrive at a fair optometry practice valuation and make informed decisions.