A Look at the Company Specific Risk Premium
What’s the secret sauce of your practice?
When we use the income approach to value a practice, part of our analysis is an attempt to quantify that secret sauce. The company specific risk premium is the piece of the valuation formula that considers all the unique and nonsystematic risk factors that characterize a dental practice.
A risk premium is the additional risk that compensates an investor for uncertainty in an investment. A practice with an overall low risk profile generally receives a higher value than a practice with a higher risk profile. Lower risk means that a successor owner will likely have a better chance of earning the same — or better — return from their investment of money, effort and time in the practice as the predecessor achieved.
Every practice has many unique attributes — financial performance, range of services, patient mix, staff expertise, office location and equipment, to name a few. Some of these attributes, such as revenues, profits and the cash distributions received by the owner, are quantifiable, while others are not. An experienced analyst understands how these different pieces come together to create value and uses these attributes to quantify the company specific risk premium for that company.
So far, no comprehensive models have been developed that translate the specific attributes of a company into a precisely quantifiable risk premium. Quantifying the company specific risk premium therefore depends on the experience and professional judgement of the analyst to assign values to the various attributes of a practice.
We’ll take a look at the most commonly used attributes for quantifying the company specific risk premium. Analysts may assign these factors a numeric value, give them a +/- ranking, or simply consider the factors in aggregate to determine an overall risk premium.
- Revenue growth. Does this show a stable, sustainable trend? Do the trends mirror the overall economy? An upward trend in revenues reduces risk for the buyer, while a downward trend might be a warning sign, particularly if the local economy is showing upward movement.
- Profitability. Is profit increasing in step with revenue? A practice that demonstrates increasing profitability over time, even with flat revenue growth, will generally be less risky for an investor than a practice with slipping profitability. We find that profitability is highly correlated with strong systems and procedures, which is why we advise all new practice owners to refrain from changing anything for the first year.
- Debt levels. A highly-leveraged practice may increase the risk to a new owner, particularly if that debt is to be assumed by the new owner. However, if the debt has been used to finance new equipment, this may be a neutral factor in the analysis.
- Business model. A specialty practice providing high-end cosmetic services may be less risky than one serving chiefly Medicaid patients. However, it can be challenging to find a prospective buyer who possesses the right technical skills. Likewise, a well-run practice specializing in Medicaid patients may perform better than a general practice with high patient turnover and poor systems. In general, any kind of practice that has efficient systems for providing efficient and effective patient care will be less risky to a buyer.
- Staff abilities, productivity, and experience. A practice with several experienced and highly-productive hygienists will generally generate higher profits for the owner than a practice without this depth of expertise. Making sure that a cohesive team remains in place after the transition is key to retaining the value of a purchased practice.
- Patient mix. A practice that relies heavily on insurance payments may not withstand economic downturns or changes in the insurance industry as successfully as one whose patients are affluent and self-pay. A mix of patients can be helpful for maintaining positive cash flow. In addition, a stable base of patients who have already received all of the more expensive treatments they’re likely to need may not be as profitable to a new owner.
- Location. A practice in an affluent neighborhood of a large city is less risky than one in a rural community whose population is declining. A practice in a downtown core may have limited parking, which may result in difficulty in attracting new patients.
- Reputation. A practice with a stellar reputation for treating patients respectfully and fairly will be less risky than one whose name has been tarnished by poor online reviews.
- Facilities and equipment. Is the office easy to find? Is parking plentiful, or is it near a transit line? Is the office attractive and inviting? Is the equipment updated and in excellent condition, or will it need to be replaced soon? Are there favorable lease provisions that can be transferred to a new owner?
An experienced analyst will weigh these factors in combination with other attributes of a practice as part of a valuation. Experience and professional judgment are critical here, for slight differences in these attributes can result in big differences in the resulting value. Many of these factors — such as reputation, profitability and staff quality — can be improved in a few years with focused effort. The result is a better selling price for the current owner, and a more satisfying experience for the next owner.
