Practice Appraisals

 

Introduction

If you plan to pay upwards of $3,500 to have your Practice appraised, it is important to understand what you are paying for. There are substantial differences between valuation methods recognized by professional business valuation organizations and rule of thumb methods often utilized within the optometric community. Recognizing the differences can provide much needed knowledge to sellers and/or buyers to understand value when considering a sale or retirement planning

The purpose of a practice appraisal is to determine the fair market value of a practice or its ownership interests to support:

• Buying or selling a business: To set a fair asking price or offer.
• Mergers and acquisitions: To assess value when combining companies or acquiring another.
• Estate and gift planning: To establish accurate values for tax reporting and wealth transfer.
• Divorce or partnership disputes: To equitably divide business interests.
• Raising capital or securing loans: Lenders and investors often require a credible valuation.
• Exit strategy and succession planning: To plan transitions in ownership effectively.
• Compliance and financial reporting: For regulatory, tax, or accounting standards that require fair value estimates.

A practice appraisal should provide an objective, defensible estimate of value that aids decision-making.

Should I Rely on Rule of Thumb Methods of Valuation? 

Valuing a private optometric practice often begins with "rule of thumb" methods. Rule of thumb methods are estimations based on industry-standard multiples applied to key financial metrics. Rule of thumb valuation methods offer a quick and straightforward way to estimate a business's value by applying industry-specific multiples to key financial metrics. While these methods can provide a general sense of Practice worth, they come with notable limitations and should be used cautiously and should be supplemented with more detailed analyses.​

Rule of thumb methods are not recognized as a standalone, standard method of business valuation by major professional business valuation organizations such as the National Association of Certified Valuators and Analysts (NACVA), the American Society of Appraisers (ASA), Institute of Business Appraisers (IBA), or the American Institute of Certified Public Accountants (AICPA). For example:

• NACVA acknowledges the use of "rules of thumb" in business valuation but emphasizes that they should not be the sole method for determining a business's value (edu.nacva.com). "Rules of thumb are acceptable as reasonableness checks but should not be used as a stand-alone method." ​
• The Institute of Business Appraisers (IBA) recognizes the use of "rules of thumb" in business valuation as a supplementary tool but also cautions against relying on them as the primary valuation method.
• The AICPA notes that “rules of thumb can serve as a reasonableness check but should not be the sole basis for a valuation. The standards emphasize that applying a rule of thumb without professional judgment does not constitute a proper valuation engagement.”

Common Rules of Thumb – Private Practices

Below are some common rules of thumb applied to the valuation of private practices and their weaknesses.

Percentage of Gross Revenue

This is a widely used method that estimates the Practice's value as a percentage of its annual gross revenue. What we most often see is that 65% of gross collected revenues used as a valuation rule of thumb by sellers and many industry sources.

The limitations of this methodology are:

• Doesn’t reflect cash flow: Investors and buyers care about how much cash the business generates — revenue alone doesn’t tell that story.
• Ignores profitability: A business might have high revenue but poor margins or even losses. Valuing based on revenue alone overlooks whether the business is making money.
• Doesn’t account for cost structure: Two Practices with similar revenues can have very different expense profiles, leading to vastly different bottom-line results — the method ignores that.
• Overlooks growth prospects: It focuses on current (or past) revenue, not on whether the business is growing, shrinking, or stagnant.
• Doesn’t consider risk: Factors like market competition, management strength, or legal issues all of which affect risk and value are ignored.
• Simplistic and potentially outdated: It often relies on anecdotal or outdated benchmarks rather than up-to-date, market-specific data.

While this method is fast and easy, it is too crude to use on its own for serious decision-making.

Multiple of EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization): This approach values the Practice at a multiple of its EBITDA, commonly between 2 to 4 times. EBITDA provides insight into the Practice's operating cash flow, making this method more reflective of profitability than revenue-based estimates.

• Ignores business-specific factors: It applies broad industry averages and overlooks unique aspects like location, management quality, customer concentration, competitive advantages, or intellectual property.
• Assumes normalized earnings: EBITDA must be adjusted (normalized) for unusual, one-time, or non-recurring items. If not done properly, the valuation can be skewed.
• Overlooks balance sheet strength: It ignores assets and liabilities that might have a significant impact on value, like excess cash, debt load, or obsolete inventory.
• Industry variability: Multiples can vary widely even within the same industry based on company size, growth rate, and risk profile — so applying a “rule of thumb” blindly can misrepresent value.
• Economic and market conditions: Multiples can fluctuate with macroeconomic trends, capital markets, and investor sentiment, which rules of thumb don’t account for.
• Ignores future potential: It’s based on historical or current performance, which might not reflect future prospects (especially for fast-growing or declining businesses).
• Risk of misapplication: Using the wrong multiple (from an incomparable peer group or outdated data) can lead to big errors in valuation.

Given these limitations, the EBITDA multiple rule-of-thumb approach should be employed cautiously in valuing optometry practices. For enhanced accuracy and reliability, it is advisable to supplement this method with more comprehensive valuation methodologies, such as the Capitalization of Earnings approach, tailored specifically to the nuances of optometry practices.

Multiple of Seller’s Discretionary Earnings (SDE): For smaller Practices, valuation may be based on SDE, which includes the owner's salary and benefits. Multiples typically range from 2 to 3 times the SDE, adjusting for factors like Practice size, location, and market conditions.

• Lack of Precision in Adjustments: The method often broadly estimates discretionary earnings, potentially overlooking critical practice-specific nuances such as owner productivity, specialized patient base, or location-specific dynamics.
• Ignores Capital Structure and Debt Service: SDE excludes considerations of debt service obligations, capital expenditures, and working capital needs, which are essential to accurately reflect true operational cash flows for an optometry practice.
• Overly Generalized Multiples: Multiples applied through this method are typically derived from generic market data, inadequately capturing unique attributes such as patient retention rates, specialized services, equipment quality, and reputation of individual practices.
• Exclusion of Growth and Risk Factors: The simplistic application of a static earnings multiple does not reflect specific market conditions, competition, regulatory impacts, or growth opportunities pertinent to the healthcare and optometric sectors.
• Limited Applicability to Professional Practices: The valuation of optometry practices often hinges on intangible assets (goodwill, patient relationships, professional reputation) that are insufficiently addressed by the generalized and earnings-focused SDE methodology.

Given these inherent limitations, the SDE rule of thumb should be employed cautiously, ideally complemented by more comprehensive valuation methodologies (such as Capitalization of Earnings) to provide a nuanced and reliable conclusion of value for optometry practices.

Asset-Based Valuation: This method sums the value of tangible assets (equipment, inventory) and intangible assets (goodwill). Goodwill is often calculated as a multiple (commonly 1 to 3 times) of the Practice's adjusted cash flow. This approach has notable limitations when applied to optometry practices due to the unique nature of professional healthcare businesses. Key weaknesses include:

• Neglects Intangible Assets and Goodwill: Optometry practices frequently derive significant value from intangible factors such as patient relationships, practice reputation, professional goodwill, and referral networks. Asset-based methods inadequately capture these essential components of value.
• Limited Reflection of Income-Generating Capacity: Asset-based approaches primarily focus on tangible assets and liabilities, offering little insight into the practice's ability to generate sustainable income, which is the primary driver of value in professional healthcare settings.
• Underestimation of Market Value: The tangible assets of an optometry practice (equipment, leasehold improvements, inventory) often represent only a fraction of total business value. Sole reliance on an asset-based approach commonly leads to undervaluation.
• Difficulty in Valuing Specialized Assets: Highly specialized optometric equipment can be difficult to accurately appraise due to limited resale markets, rapid technological obsolescence, and depreciation challenges.
• Inappropriate for Going-Concern Valuations: Asset-based methodologies are primarily suited for liquidation scenarios rather than ongoing practices. Optometry businesses typically operate as going concerns, making an income-based or market-based valuation more appropriate.

Given these limitations, the asset-based approach should generally serve as a supplementary reference rather than a primary method in valuing optometry practices.

Debt Service Coverage Model: This method looks at the Practice’s ability to service debt based on its adjusted cash flow as determined by the appraiser. This method has inherent limitations when specifically applied to optometry practices. These weaknesses include:

• Limited Focus on Debt Capacity Rather Than True Business Value: The DSC model emphasizes loan repayment capabilities rather than intrinsic value, potentially undervaluing practices with minimal debt or superior profitability and cash flow generation.
• Ignores Non-Financial Intangible Assets: This approach inadequately accounts for intangible components—such as professional goodwill, patient retention, location desirability, and practitioner reputation—which significantly influence optometry practice values.
• Insufficient Reflection of Growth and Strategic Potential: A debt service coverage-based valuation typically does not capture the potential for future growth, expansion opportunities, or strategic value, focusing instead on static historical or current financial performance.
• Highly Sensitive to Debt Structuring Assumptions: The valuation outcome can vary considerably based on assumed debt terms, interest rates, and amortization periods, potentially leading to misleading or inconsistent conclusions.
• Limited Applicability as a Standalone Valuation Method: DSC analysis provides useful validation for financing feasibility but lacks comprehensiveness as a primary valuation approach, necessitating complementary methodologies such as income-based or market-based analyses.

Given these limitations, the Debt Service Coverage model should primarily serve as a secondary verification tool rather than a standalone method in determining the valuation of an optometry practice.

Professionally Recognized Methods of Business Valuation

​In professional business valuation three primary approaches to valuation are recognized:

Income Approach: This approach estimates a business's value based on its ability to generate future income and is often the most reliable method applied to the valuation of private Practices. Common methods include:​

• Capitalization of Earnings/Cash Flows: Used when future earnings are expected to be stable. It involves dividing expected earnings by a capitalization rate to determine value.​
• Discounted Earnings/Cash Flows: Applied when future earnings are expected to vary. It involves discounting projected future earnings to their present value using an appropriate discount rate.​

Market Approach: This approach determines value by comparing the subject business to similar businesses that have been sold or are publicly traded. Common methods include:​

• Guideline Public Company Method: Values the business based on valuation multiples derived from publicly traded companies in the same industry.​
• Guideline Transaction Method: Uses pricing multiples from actual sales of comparable private businesses.​

These methods are recognized in valuation standards and are commonly used when reliable market data is available. ​

Asset-Based Approach: This approach calculates the value of a business based on the fair market value of its assets minus its liabilities. Common methods include:​

• Book Value Method: Uses the values from the company's balance sheet.​
• Adjusted Net Asset Method: Adjusts the book values of assets and liabilities to reflect their current fair market values.​

This approach is particularly useful for asset-intensive businesses or in liquidation scenarios and are typically not applicable to private Practices. ​

These approaches are foundational in business valuation and are supported by professional standards set forth by organizations like NACVA, ASA, and AICPA. Business appraisers often consider multiple approaches to arrive at a comprehensive and reliable valuation.

What Business Valuation methods are most applicable to optometry practices?

The Capitalization of Earnings Method is generally considered the most appropriate approach for valuing optometry practices due to the specific financial and operational characteristics of these professional healthcare businesses. Key reasons supporting its suitability include:

• Focus on Sustainable Earnings: Optometry practices primarily derive their value from the consistent and predictable income streams generated by professional services. This method directly capitalizes these normalized and ongoing earnings, providing an accurate reflection of the practice's value as a going concern.
• Capture of Intangible Value and Goodwill: Significant intangible assets such as patient loyalty, practitioner reputation, referral relationships, and established brand equity substantially influence the value of an optometry practice. The capitalization of earnings approach inherently considers these intangible factors by emphasizing earnings derived from goodwill and established patient bases.
• Alignment with Market Expectations: The method is widely accepted and recognized within the healthcare industry, aligning closely with market participants' typical valuation approaches, thereby supporting practical transaction comparability and transparency.
• Simplified Application and Communication: The Capitalization of Earnings Method is straightforward and easily communicated to buyers, sellers, and lending institutions, making it particularly suitable for optometry practice transactions and facilitating clearer negotiations.
• Reflects Industry Stability and Risk Profile: Optometry practices often exhibit relatively stable growth, limited volatility, and predictable profitability. The capitalization approach appropriately incorporates these industry-specific risk characteristics within the capitalization rate selection.

Given these strengths, the Capitalization of Earnings Method is typically the most effective and reliable valuation approach for optometry practices, providing a meaningful representation of their economic value as ongoing professional entities.

Best Practices for Accurate Practice Valuation

The first step is to prepare a detailed financial analysis of the Practice analyzing the financial statements, cash flows, and profitability metrics to gain a clearer picture of the Practice's historical financial performance. It is critical that a buyer and/or seller understand the financial as well as operational performance of the Practice. Once this information has been developed, you can apply rule of thumb methods for an initial estimate of the Practice value; however, you should proceed with more comprehensive valuation techniques for accuracy.

Consult with professional appraisers who have experience evaluating optometry practices to obtain a thorough and objective assessment.​ Using a broker or consultant with existing consulting contracts, contingency fee arrangements, dual representation of the buyer and seller, future engagement expectations, or those who have a financial stake in the sale of the practice, direct or indirect should not be relied upon to perform a formal valuation due to the potent conflicts of interest.  You should consider obtaining an opinion or engaging a credentialed, independent valuation professional to ensure accuracy, fairness, and objectivity in valuation outcome. Before engaging a business appraiser seek clarification as to what methods of valuation will be used in determining the value of your Practice. This process will provide the buyer and/or seller with the knowledge to appropriately price the Practice for sale which will facilitate negotiations.

In summary, while rule of thumb methods provides a convenient starting point for valuing a private optometric Practice, they should not be the sole basis for decision-making. A comprehensive business valuation that considers the Practice's unique characteristics, financial health, and market conditions will yield a more accurate and reliable estimate.​

If you have any questions regarding this information or the valuation of your practice, please feel free to contact Ken Ferreira, Chief Executive Officer at Vision One Credit Union, kferreira@visionone.org.

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