A closer look at common valuation approaches: Market-based approach

Editor’s note: This is part one of a four-part series on practice valuation approaches. Read part two here.

Determining your practice’s worth is critical. While most business owners can precisely assess the worth of a practice’s tangible assets—such as dental equipment, instruments, computers, and other assets—their estimates regarding the overall practice’s value often remain subjective, imprecise, and debatable. Knowing your practice’s value is crucial—not only for transactions such as sales, acquisitions, or mergers—but also for crafting accurate medium- to long-term strategies.

In Dental Economics, we have previously examined a general view of dental practice valuation. Now, we’ll explore one of three traditional valuation approaches to help you better understand your options for valuing your practice.

The three traditional valuation methods

There are many methods out there, so finding the ones that work best for you will take some time. In this article, we’ll review one of the “big three” approaches—the market--based approach—so you can familiarize yourself with the pros and cons of this most common method of practice valuation.

Market-based approach

A market-based approach, as the name suggests, utilizes principal market data to establish the value of a dental practice. This is also referred to as the comparable sales approach.

When using this method, one relies on the metrics of comparable dental practices that have recently sold, preferably in the same general geographic region. In many ways, this approach is similar to residential real estate valuations that compare recently sold houses in close neighborhoods to estimate the worth of a property.

Determining a business’s value by comparing it to similar entities that have been traded in the market is also known as relative valuation.

The market-based approach should not be simplified because it is not based on a simple comparison of values and is not an attempt to “match” the values of different business entities. This method involves analyzing actual market transactions linked to practice performance to establish a business’s value.

The underlying principle of the market approach is that comparable assets (in our case, dental practices) will trade at comparable prices when market conditions are efficient. While market comparables are utilized to ascertain a business’s value, these estimates alone should not dictate the practice’s final value.

There are challenges, of course. While the market-based valuation method is straightforward and relies on actual market statistics, locating comparable and validated data can sometimes be tricky. This becomes especially challenging in rural areas and new urban developments. The effectiveness of the market-based approach is enhanced when there is an ample number of comparable businesses and assets either recently sold or available for sale in the market when the sales data is readily available. It must be emphasized that some dental practice sales data remains confidential, reducing the pool of available data for valuation purposes.

Market-based approach valuation methods

Two distinct valuation methods are used under the market-based approach: public company comparables and precedent transactions.

Public company comparables: This method applies to publicly traded companies and is not primarily applicable to individual dental practices. When large-scale DSO sales take place, this method is rightfully used to evaluate similar subject entities. In most situations, it is difficult to compare smaller and larger DSOs because they are dissimilar in market demands, supply factors, operational processes, and financial composition.

Precedent transactions: This method is better suited for individual dental practices because it derives value using pricing multiples from recorded transactions. While comprehensive financial data for most practices is not readily available, transaction value is usually available through transaction brokers.

Both market valuation methods assume that the practices are comparable. When a practice is comparable enough to be used in determining the value of the other practice, the valuator should consider several additional factors, such as:

• Whether the practices are operating in a similar economic environment
• Whether they are similar in size
• Whether they offer identical or similar services
• Whether they compete within similar patient groups
• Whether they have relatively identical revenues, profits, and expenses
• Whether they have similar capital structures
  
  

Valuation multiples

The metrics that link the operational data with sales value are called valuation multiples. Corporate Finance Institute defines valuation multiples as “financial measurement tools that evaluate one financial metric as a ratio of another to make different companies more comparable.”¹

Multiples are derived as proportions of one financial metric of the practice to another (such as revenues, EBITDA, and net income). Multiples are widely utilized in valuation practice, especially in cases where there is no direct comparability between practices.

The weakness of such a universal application is that some transactions affecting valuation multiples may have happened in significantly diverse markets or under adverse conditions; therefore, they do not adequately represent the prevailing acquisition environment. This became more evident than ever in the post–COVID-19 environment. It is essential to understand that some distressed transactions negatively affect valuation multiples.

Factors that lower the valuation multiple

The factors that negatively impact valuation multiples include:

• Excessive reliance on a small patient pool: When practice operations are overly dependent on a small core of patients, this increases the risk associated with the business. For example, if 50% of your patients generate more than 80% of your practice’s revenues, the future earnings will be contingent on these patients. The risk associated with such a practice’s future cash flow increases significantly and the valuation multiple used decreases accordingly.
• Dependence on owner and personal goodwill: If your practice is overly dependent on the doctor’s personal skills, the transferability to the new practitioner and future cash flow stream to new owners becomes questionable. Without a transition period, such “personal goodwill” will significantly reduce the value, affecting the price a potential purchaser would be willing to pay for your practice.
• Volatility in earnings: Earnings volatility creates uncertainty, and uncertainty increases risk. Revenue and net income fluctuation will force potential purchasers to apply reduced valuation multiples to your practice compared to earnings that have been stable or have been increasing over time.²
  
  

Pros and cons

Both methods used under the market approach have their advantages and disadvantages, implying that this approach itself offers both benefits as well as disadvantages.

Advantages of a market-based approach to valuation

• Simplicity: The market-based approach is straightforward, practical, and requires simple calculations.
• Uniformity of the subjects: In this process, the valuator compares apples to apples, which is inherently relevant. In dental valuations, we compare any given dental practice to other dental practices.
• Reliability: Assuming the valuator is using actual practice sales prices within reasonable geographic areas, the valuations are more reflective of genuine values.
• Validity: This methodology uses valid, public, verifiable data.
• Objectivity: This methodology is not dependent on subjective forecasts.
  
  

Disadvantages of a market-based approach to valuation

• Limitation of data available: In the marketplace, where most sales are private, getting enough market data to make a reasonable comparison can be challenging.
• Not entirely reflective of ­practice competitive advantage: If your dental practice has unique features that benefit your competitiveness, this method may not capture that value.
• Limitations of comparative data: It is difficult to identify practices or transactions for the practices that are ideally or closely comparable to each other.
• The market-based approach is less flexible compared to other valuation methods.³
  
  

Conclusion

Determining the value of your practice using the market-based approach is particularly suitable in many situations, such as:

• When you want to either set the listing or consider the offer price for your practice
• When you need to see if the valuation of the practice realistically reflects market conditions
• When you need to defend the valuation of your practice before the tax authorities or in a legal dispute such as divorce or partner disagreements

Although deciding whether one dental practice is truly comparable to another can be a complex task, the positive side to this process is that you can compare similar types of businesses (e.g., dental practices) that are unique yet somewhat similar. Despite the general opinion that the market-based approach lacks flexibility and does not fully account for the business’s future earning potential or associated risks, this approach to business valuation remains a statistically sound methodology. 

Disclosures: The authors have no financial interest in any of the companies mentioned in this article.

Editor's note: This article appeared in the June 2024 print edition of Dental Economics magazine. Dentists in North America are eligible for a complimentary print subscription. Sign up here.

References

1. CFI Team. Types of valuation multiples. The different types of multiples used in analysis. Corporate Finance Institute. 2023. https://corporatefinanceinstitute.com/resources/valuation/types-of-valuation-multiples/
2. Valuation multiples: convenient but dangerous. GCI Investors. August 23, 2019. https://gci-investors.com/valuation-multiples-convenient-but-dangerous/
3. The market approach: pros, cons and other considerations. GBQ. April 25, 2016. https://gbq.com/the-market-approach-pros-cons-and-other-considerations/