Understanding Practice Value
The details that add up to a more accurate valuation.
By Steve Stalzer, PT, MSPT*
Understanding the value of your business is not only critical for owners focused on near-term succession planning, but also invaluable for those working to build value for an exit that may be years away.
While there are several methods for assessing the value of a business, this article will focus on the market approach which is the most commonly used valuation method within the physical therapy industry.
Using this approach, the market-based multiple is multiplied by the most recent 12 months of adjusted EBITDA (earnings before interest, taxes, depreciation, and amortization). This article outlines the steps and many of the details associated with calculating the value range for a physical therapy practice.
CALCULATING ADJUSTED EBITDA
Calculating EBITDA is relatively straightforward. It simply involves calculating your net ordinary income before interest, taxes, depreciation, and amortization are deducted. It is helpful to look at trends over the past two or three years as well as the trailing-12-month EBITDA. Trailing-12-month EBITDA is simple a sum of the most recent 12 months of financial data and can be calculated easily if you export your P&L into Excel. The “trailing-12” is typically used by buyers as it most accurately reflects the current state of the business.
Once EBITDA is known, the next step is to calculate appropriate adjustments to normalize earnings and account for “owner add-backs.” The most common adjustments are in the following areas: 1) owner salaries, 2) personal expenses, and 3) one-time expenses. The goal of this exercise is to off-set any personal expenses that are not essential to operate the business going forward. As simple as this sounds, there are many misconceptions about what typically counts as an add-back and what does not.
Owners’ salaries should be compared to an estimated market replacement salary. If an owner earns $200,000 in salary but plans to reduce their salary to $120,000 (the market replacement salary) after a transaction, the add-back would be $80,000. It is important to note that only salary earnings are used in this calculation. Profit distributions are not utilized, as profits are accounted for in the EBITDA calculation. If an owner is paying themselves less than the market replacement salary, that amount would be deducted from EBITDA rather than added to it. An owner with a salary of $80,000 would need to deduct $40,000 from EBITDA if the replacement salary is $120,000.
Many business owners have personal expenses that are run through the business. Since these are not indicative of future expenses to operate the business, they are also counted as add-backs. Examples may include personal auto expenses, personal travel, family meals, or family phones. What does not count an as add-back is any expense that contributes to marketing or operating the business. Examples may include sports tickets used for marketing or travel between clinics for staff meetings.
Efficiencies brought by a buyer are also not considered add-backs for the seller. Accounting, legal, health insurance for staff, and billing are all expenses going forward. Even if the buyer has a lower cost for those services, the difference is not credited to the seller.
“One-time expenses” that are typically counted as add-backs include practice consulting or executive coaching and unique or unusual legal or accounting costs. Start-up costs can also be counted as a one-time expense for clinics that were opened within the past year so long as that expenses were not already captured in the depreciation adjustment.
UNDERSTANDING MARKET-BASED MULTIPLES
Once adjusted EBITDA is calculated, the next question becomes what multiple should be used to establish the value range. Multiples vary significantly based on four primary factors: 1) company size/EBITDA, 2) leadership, 3) growth trends, and 4) risk factors. Just because your colleague sold a practice for “X” multiple does not mean that your practice will command the same if these factors are significantly different.
The size of the practice and total EBITDA matter. Everything else being equal, larger practices command higher multiples than smaller practices. While the number of locations and total revenue are important, EBITDA is what pays the bills and what typically drives an increase in the multiple range. A company with $5 million in EBITDA is likely to command a multiple that is nearly double that of a clinic with $500,000 of EBITDA.
Strong and proven leadership is critical as well. Owners looking to “stay in the game” and who are engaged in continuing to grow the business are often more attractive for buyers. Owners seeking to exit within the ensuing 12-24 months after selling may drive value ranges down if the seller does not have a proven leader able to step in to operate the business going forward. Strong leadership across clinic director and key marketing positions is ideal as well.
Past growth rates are one of the best predictors of future growth. Physical therapy is a growing industry and buyers are typically looking for practices with proven growth trends. Practices with higher growth rates typically command higher multiples than those with lower annual growth.1 Practices with no annual growth are likely to be viewed as “tired” and are likely less desirable for most buyers.
The last driver is risk. Risk factors will be viewed uniquely by all buyers and, in this author’s experience, generally include referral concentration, competition, compliance, profitability, lease terms, business contracts, staff turn-over, market growth and rates. Practices with a lower number of risk factors will command higher multiples than a practice with significant risk factors.2 Working to decrease risk factors not only drives value up but is also good for the health of the company regardless of succession plans and timelines.
If you have questions on current multiple ranges, you may consider talking with a consultant or M&A advisor that specializes in the physical therapy industry. Since most clinic transactions are private, there is very limited data publicly available on multiple ranges and other industry multiples often lag those in the physical therapy industry. No matter what you see in the future for your practice, it’s important to understand its value and how you the decisions you make impact it.
1Morones S. Develop your intuition about valuation multiples. Morones Analytics website. https://moronesanalytics.com/develop-your-intuition-about-valuation-multiples/. Accessed November 6, 2020.
2Mahmood D. How to take risk out of your company. Inc. https://www.inc.com/david-mahmood/how-to-take-risk-out-of-your-company.html. Published September 12, 2013. Accessed November 6, 2020.
Steve Stalzer, PT, MSPT, is an M&A Advisors at 8150 Advisors. He can be reached at email@example.com.
*The author has a professional affiliation with this subject.