Here are many of the terms you’ll hear tossed around inside the topic of veterinary practice valuation
EBITDA
Stands for Earnings before Interest, Taxes, Depreciation and Amortization
Depreciation
An accounting method to proportionally spread the expense of a tangible asset over the lifetime of the asset.
Amortization
An accounting method to proportionally spread out the expense of INtangible asset over time. Both amortization and depreciation are done according to rules/schedule provided by the IRS.
Capitalization Rate
Net earnings/sale price of business.
Discount Rate
Risk defined as a percentage of interest that investors want as compensation against the uncertainty of future earnings. In other words, your practice’s future gross revenues are not a given. An investor wants those earnings to represent a certain yield (in our profession this is typically 15% or more) before the risk of the investment seems worthwhile.
Weighted Average Cost of Capital (WACC)
The sum of the cost of debt and the opportunity for earnings locked up in Equity. The WACC is used as a jumping off point to determine the Discount Rate.
Cost of Equity
Risk free interest rate (return on a US Treasury Note …roughly 3.5%) + Average Return from the Stock Market/Funds above the Risk Free Rate (you can use a conservative 8%) +Inflation (currently 1.75%)
Cost of Debt
Current interest rate on existing debt minus any tax breaks one gets on interest paid. Formula is Interest Rate of Debt x (1-% tax deduction)
Discounted Cash Flow
Today’s value of the sum of all future cash flows. Example: Let’s assume that a business will provide you with 75000 in net profit in three years. You would like to have an ANNUAL rate of profit of 15%. The formula to determine today’s value of tomorrow’s earnings is: Total Returns/ (1+Interest Rate)n , where n is the number of years it takes to earn the return.
Capitalization of Earnings
The future earnings of a company divided by the Capitalization Rate
Earnings Capitalization Model for Veterinary Practice Valuation
A buyer offers to purchase a business’s future earnings for the same amount of money he would have to invest to earn those earnings in an investment of similar risk. For example, let’s assume you are buying Old Faithful and you can sell the water Old Faithful produces each year for 100,000. Since Old Faithful will produce water forever and since everyone will always need water, we can assume that this business venture is very reliable. When determining a price, the seller asks herself…where else could the buyer invest their money and have such a guaranteed return? The answer might be a Treasury Note which yields 3% interest. If we divide the 100K by the T-note’s interest of 3%, we determine that the buyer would have to invest 3.3 million dollars to achieve the 100K that Old Faithful generates. Both the buyer and the seller in this case can agree that the sale price for Old Faithful can go as high as 3.29 million dollars and still be decent buy.
Excess Earnings Model (EEM)
You can think of the EEM as a more detailed look at Earnings Capitalization. In the EEM, valuators attribute more risk to the earnings of intangible assets than to the earnings of tangible ones. Here’s an example. A veterinarian owns a practice and the building in which it is contained. He paid 200K dollars for the building and he charges himself 20K each year for rent. His return on the building investment is 10%. The practice generates 80K dollars worth of net revenue each year, but don’t forget that 20K dollars was taken out as an expense to the business. If we were to valuate this business using the Earnings Capitalization Model, we would divide 80K by the capitalization rate (let’s assume it is 20%) and come up with a price of 400K for the business. But what if the practice owned the building? Then we wouldn’t have the 20K rent and our net earnings would be 100K or 500K in capitalized earnings.
But this doesn’t make sense. We would expect to price for the practice to include the full 200K for the building AND the value of the business. In the Excess Earnings Model, we would capitalize the earnings of the building (in this case 20K) separately at 10% and the rest of the earnings from intangible sources at 20%. The new result is 20K/.10 + 80/.20= 600K dollar for the practice if it includes the building.
Pricing Formulas
Mark Up= Price-Cost/ COST
Example: We sell 1 box of kitties for 100 dollars. We paid 50 dollars for the box of kitties (why we PAID for a whole box of kitties when they end up on our door step all the time free of charge is beyond me, but that’s what we did). Our MARK UP on the kitties is 100-50/50= 100% or 2 times their cost
Margin= Price-Cost/ PRICE
Example: Same box of kitties…100-50/100=50% or we have a NET return of 50% on the price that was charged to the fool that bought the box of kitties
Pricing is a margin problem, not a markup problem. Remember that MARGIN is where we are going, MARKUP is how we get there. Here’s why…take a look at your profit loss statement.
Gross Revenue
-COGS
________
Gross Profit
–Fixed Expenses
________
Net Profit
On the Profit and Loss Statement, net profit is typically represented as a percentage to Gross Revenue. This is a MARGIN expression (Price-Cost/Price) since:
- Gross Revenue is the sum of all of the prices you charged
- COGS and Fixed Expenses are the sum of your costs
- and the % net return is the difference between the two divided by the Gross Revenue.
It’s important that if you want to achieve a certain margin, that you use the above formulas to determine the accurate markup to apply, and to remember that this number will not equal your margin.
Pricing Formula
To directly compute price, sum your TOTAL cost (including fixed/labor costs) and divide this number by margin % (as expressed as a decimal) and subtract 1)
Price= Cost/(Margin-1)