Attention Dental Practice Owners:

Understanding Adjusted EBITDA as the Driver of Practice Value for DSOs and the Impact of Additional Profit

EBITDA is an acronym that stands for Earnings before Interest, Taxes, Depreciation, and Amortization and is commonly used by the financial and investment community as a measure of a business’ free cash flow on a pre-tax basis.

EBITDA allows analysts to focus on the outcome of operating decisions while excluding the impacts of non-operating decisions like interest expenses (a financing decision), tax rates (a governmental decision), or large non-cash items like depreciation and amortization (an accounting decision).

By minimizing the non-operating effects that are unique to each company, EBITDA allows investors to focus on operating profitability as a singular measure of performance. Such analysis is particularly important when comparing similar companies or companies operating in different tax brackets across a single industry.

Private Equity funds universally use EBITDA to evaluate the companies they invest in and given the vast majority of DSOs are backed by private equity, the methodology rolls downhill, and most DSOs use EBITDA to value practices.

Valuation analysts use adjusted EBITDA to arrive at a more accurate assessment of a practice’s operating performance. What does this mean – adjusted EBITDA?

Standardizing EBITDA by removing anomalies means the resulting adjusted or normalized EBITDA is more accurately and easily comparable to the EBITDA of other companies and to the EBITDA of a company’s industry as a whole.

Key Takeaways

·         The adjusted EBITDA measurement removes non-recurring, irregular, and one-time items that may distort EBITDA.

·         Adjusted EBITDA provides valuation analysts with a normalized metric to make comparisons more meaningful across a variety of companies in the same industry.

Adjustments to EBITDA are simply steps to make the number and any resulting conclusions more accurate. Adjustment examples might include adding back personal expenses written off through the business, one-time non-recurring equipment purchases, and other similar adjustments to make the EBITDA figure more accurate and representative of what can be expected by a buyer post-transaction.

Adjusted EBITDA gives an accurate measure of a practice’s operational results and an assessment of the expected pre-tax free cash flow. But this is only half the story and not sufficient by itself to determine practice value. Generally, buyers of businesses, and in this case, your dental practice, are prepared to pay a multiple of adjusted EBITDA. Multiples are often expressed as a number and times or a number and x. Thus, a five times multiple is expressed as 5x. This means that the buyer is willing to pay five times the adjusted EBITDA in purchase price, or at a minimum, to ascribe that figure as the enterprise value of your practice.

Depending on the deal structure, the buyer may not be paying all of the enterprise value in cash. Perhaps they will be buying a fractional interest, with you retaining some interest yourself post-transaction, or perhaps they will ask you to hold a seller note for some portion of the purchase. The important thing to remember is that the term enterprise value refers to the total value of your practice.

Multiples vary across industries based on profitability, performance in recessionary climates, the need for CAPEX investment, and countless other factors. The average multiple across all industries is 3x. Fortunately, for dental, it is higher. Individual practices have been acquired for the most part for multiples ranging from 5 to 6x – sometimes lower and, in some instances, higher.

There are a number of factors that influence where a particular practice falls in the prevailing multipl4 range for dentistry. The first is scale; the larger the practice and the higher the adjusted EBITDA, then, usually, the higher the multiple. Another factor is whether or not there is an expected requirement for capital investment; how old is the equipment, and will the facility need to be renovated/upgraded? The greater the investment required, the lower the multiple. Other factors may relate to expectations around margin improvement and growth. If the buyer believes they have a clear line of sight to EBITDA improvement then they will be more likely to pay a higher multiple.

Every transaction is a balancing act between perceptions of value and perceptions of risk. The logic is straightforward – higher perceived value results in a higher multiple, and a higher perceived risk results in a lower multiple.

Examples of issues that drive perceptions of risk include a high concentration of Medicaid patients. Government reimbursement can change with the stroke of a pen. Plus, there have been many examples of Medicaid fraud within the profession, and most DSOs would rather not deal with it. Other examples of risk factors may include the recent departure of a high producing associate or problems with regulatory compliance or quality of care issues. It is easy to see how a buyer would be influenced by these concerns.

Now, let’s examine the impact of additional profit on practice value.  Each incremental dollar of profit simply becomes an additional dollar of adjusted EBITDA.  Depending on the multiple, each dollar of additional profit results in that dollar times the multiple being the increase in practice value.  Using a multiple of 6x – each dollar of increased profit results in six dollars of increased practice value.

The implication is profound and creates an imperative around the need to become profit focused.  More on this in future issues.