VALUATIONS / PRACTICE APPRAISAL

Why the Excess Earnings Method is NOT Always the Answer in
Valuing a Veterinary Practice

By Tom A. McFerson, CPA, ABV

A common question we are often asked is how do you value a rapidly growing veterinary practice in a way that does not short-change the seller or overcharge the buyer?

Valuation Methods

There are three standards of value, with the most widely accepted being Fair Market Value. The formal definition established by the American Society of Appraisers is “the amount at which property would change hands between a willing seller and a willing buyer when neither is acting under compulsion, and when both have reasonable knowledge of the relevant facts.” This definition assumes, among other things, both the buyer and seller are typically motivated, that both parties are well informed, and that the price is unaffected by special or creative financing or sales concessions granted by anyone associated with the sale.

The most critical aspect in determining the fair market value of a veterinary practice is choosing the appropriate valuation method. In doing so, the appraiser must carefully look at important factors such as the purpose for the valuation, the length of time the practice has been in business, and the growth trend of the practice. A specific valuation method might be more appropriate, given a certain set of facts, then another. Following are some different approaches:

Rule of Thumb While not a formal “method” of valuing a veterinary practice, it is a simplistic way of figuring a ballpark value for your veterinary practice. Many industries have rules of thumb about how companies are valued. For instance, a Dental Practice is generally valued at 35 to 75 percent of the latest year’s revenues. In our industry, veterinary practices are generally valued at 65 to 100 percent of last year’s gross.

The problem with relying on rules of thumb is that they do not recognize the differences between one practice and another. There are too many factors involved to rely solely on rules of thumb in arriving at a value. It should really only be used as support for a proper valuation.

Comparative Transaction Method A value is established by relying on information gathered from similar transactions. Some appraisers prefer this method because a value is determined based on the real world, i.e. actual veterinary practices bought or sold in the marketplace. They liken it to buying a house, with your real estate agent looking for comparable sales in the neighborhood. Unlike homes, though, veterinary practices can be extremely unique. The challenge of this method lies in finding veterinary practices that are truly comparative to the one being valued.

In trying to find truly comparative practices, the following elements, at a minimum, must be considered:

• Gross revenues, components of gross revenues, earnings before depreciation, interest and taxes (EBDIT), cash flow, and discretionary earnings

• Value of tangible assets and intangible assets

• Sale of assets or stock?

• Terms of the transaction. Size of down payment, seller financing, interest rate, term on note and allocation issues

The problem with the comparative transaction method is finding enough truly comparable transactions to base a value on. To successfully use this method, you would need to find at least five similar veterinary practices that have sold in the last three years. And, depending on other details, these still might not be truly comparable.

Capitalized Excess Earnings Method This tends to be the most commonly used, perhaps over used, method of valuing a veterinary practice. It is a combination of valuing the tangible and intangible assets of a practice. It is best used when there is some consistent historical financial information to use. The typical steps involved in this process are as follows:

1. Estimate the net tangible asset value for the practice

• Drugs and supplies, estimated at their cost

• All equipment and leasehold improvements, based on cost, age, condition, usage

2. Estimate excess earnings. You should use a minimum of four years worth of historical data. Each year should be normalized, and then the four should be weighted accordingly. Some items you should pay close attention to:

• Adjust any excessive owner compensation down to a normal salary for an owner-operator in the area.

• Adjust for any excessive rent that the owner pays himself/herself. If no rent is charged, adjust to a fair market value rent for the area.

• Adjust for any non-cash items.

• Adjust for any owner fringe benefits, or “goodies.”

3. Estimate an appropriate capitalization rate to apply to the excess earnings. The capitalization rate is based on the risk involved in owning a veterinary practice. While their will always be some risk, in theory, the better the practice, the lower the risk; the lower the risk, the higher the value.

4. Apply the capitalization rate to your excess earnings. This is the value of the intangible assets of the practice. Then add the value of the tangible assets. You now have a total value of the practice.

One of the positives to this method is, as a popular valuation method in our industry, most veterinarians are familiar with it. The danger, however, is that it can be oversimplified. Yes, it is formula based, but each step through the process has many possibilities and variables.

One of the key components of this method is the normalization of earnings. The temptation is to make adjustments for items such as excess compensation, excess rent, and all of the other “goodies” that the owner is running through the business. The rational behind this is that, for an outside party buying the practice, the extra rent and “goodies” are expenses that the new owner will not have. But what about for an associate who is buying in? Does the current owner plan on changing his behavior, as it relates to the practice paying for his “goodies”? If the answer is no, then these adjustments to the excess earnings should not be made. You would be charging your associate for cash flow that is not really there.

The excess earnings method is better suited for a practice that is experiencing stability, that has been in business for several years and is growing at a stable pace. This method uses historical data, so a practice that is experiencing rapid growth will not see the results of that potential growth reflected in the value.

Discounted Economic Income Method

While the excess earnings method looks to the past for its value, the discounted economic income method looks to the future. The basic idea behind this method is to calculate the value based on projected net cash flow for some future period, and then to discount them to the present value based on the potential risk involved. Some key steps:

1. Establish what the net cash flow of the practice is going to be. Depending on the situation, the net cash flow is going to be the true net income of the practice, plus non-cash charges such as depreciation. Like the excess earnings method, excessive owner salary, rent and goodies again become a factor.

2. The present value discount factor is basically the rate of return the industry requires for a similar veterinary practice. As mentioned before, the higher the risk the higher the rate of return required. The lower the risk, the lower rate of return required.

3. The other key factor to this method is the number of future years to project out and use in the calculation. There is no absolute answer, but most business appraisers seem to use at least four.

The positives to this method are that it does take into consideration a changing business. Historical data does not do much good if a practice’s gross is growing (or shrinking) by thirty percent per year. The negatives are that you are dealing with future projections and, depending on the assumptions for gross growth, expense items growing or shrinking, staff needs, etc., these can vary widely.

This is simply an overview of several different valuation methods that are currently being used in the veterinary industry. Each method has its own pros and cons, its own simplicities and complexities. The important thing to remember is that no two veterinary hospitals or clinics are the same. Where the practice is going, where it’s coming from, how it’s run, these questions and several more are all vital in establishing what valuation method to use, and ultimately, your practice’s value.

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