For decades, dental practices have been valued using a straightforward formula based on a percentage of annual collections. Typically, practices sell for anywhere from 70% to 100% of collections, depending on factors like location, patient base, and overall desirability. While this approach has served the industry well, the landscape is shifting. As dental service organizations and private equity investors enter the market, they’re bringing a different valuation methodology with them, one centered around a metric called EBITDA.
Understanding EBITDA is becoming increasingly important for practice owners, whether you’re considering a partnership, planning for retirement, or simply want to understand your practice’s true value in today’s market. Let’s break down what this acronym means and how it’s calculated.
What Exactly Is EBITDA?
EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortization. At its core, this metric measures the cash flow your practice generates. Investors and analysts favor EBITDA because it provides a standardized way to compare investment opportunities across different industries or evaluate multiple practices within the dental sector. By removing variables like financing structures, tax strategies, and accounting methods, EBITDA reveals the fundamental profitability of your operation.
When dental groups evaluate acquisition opportunities, they typically apply a multiplier to your EBITDA, commonly ranging from four to six times. This approach differs significantly from the traditional percentage of collections model and can sometimes result in very different valuations.
Calculating Your Practice’s EBITDA
Let’s walk through a practical example using a practice with one million dollars in annual collections. Assume the dentist produces $750,000 while the hygiene department generates $250,000.
Starting with your total collections, the first step is determining gross profit by subtracting overhead expenses. This includes laboratory fees, supplies, utilities, and team member salaries. If these expenses total $600,000, your gross profit would be $400,000.
Here’s where the calculation becomes nuanced. Notice that we haven’t yet factored in doctor compensation. This is intentional and represents a critical difference from how your CPA likely structures your current financials. When evaluating EBITDA for acquisition purposes, groups model your compensation based on what it would be after joining their platform, not your current arrangement.
In your existing practice, you probably structure compensation in a tax-advantageous way, taking distributions through retirement contributions, automobile expenses, and perhaps employing family members. These strategies make perfect sense for independent practice ownership, but they don’t reflect the economic reality of how the practice would operate under new ownership.
In our example, let’s assume post-acquisition compensation would be 30% of doctor production. That would be $225,000 (30% of $750,000). Subtracting this from the $400,000 gross profit gives us an adjusted gross profit of $175,000.
The Power of Addbacks
The final step involves adjusting for what are called addbacks. These are expenses currently running through your practice that wouldn’t exist after a transaction. Common addbacks include personal vehicle payments, cell phone bills, family members on payroll, and personal travel expenses classified as business expenses. In our example, let’s say these total $20,000.
Additionally, we add back interest, taxes, depreciation, and amortization. While not every practice will have significant amounts in these categories, they’re important components of the calculation. Let’s assume these add another $15,000.
Adding these $35,000 in total addbacks to the $175,000 adjusted gross profit yields an EBITDA of $210,000. This represents a 21% EBITDA margin, calculated by dividing the EBITDA by total collections.
What Makes a Strong EBITDA Margin?
Most dental groups target practices with EBITDA margins of 20% or higher. This threshold indicates efficient operations and strong profitability potential. If your practice falls below this benchmark, it doesn’t necessarily mean it lacks value, but it may signal opportunities for operational improvements or indicate that your current expense structure includes items that would be adjusted in a transaction.
Understanding your practice’s EBITDA gives you valuable insight into how investors view your operation. It also helps you identify opportunities to enhance value before a potential transaction. Whether you’re planning to partner with a dental group in the near future or simply want to operate your practice more efficiently, knowing your EBITDA is essential.
Take the Next Step
Navigating practice valuations and understanding the financial metrics that drive them can feel overwhelming, but you don’t have to figure it out alone. At DentalCPA, we specialize in helping dental professionals understand their practice’s true value and optimize their financial performance. Whether you’re considering your options for the future or want to maximize your practice’s profitability today, our team has the expertise to guide you through every step of the process. Contact us today to schedule a consultation and discover how we can help you achieve your professional and financial goals.