If you’re considering purchasing a physical therapy or accounting practice, accurately valuing your target business is a vital step. The right valuation method can help you avoid overpaying and ensure your investment is financially sound and aligned with your goals.
Two of the most essential approaches for buyers are the Leveraged Buyout (LBO) analysis and the Discounted Cash Flow (DCF) model. By understanding the differences between the two valuation methods, you’ll be better equipped to make informed, confident decisions throughout the buying process.
Private equity firms often conduct an LBO analysis to gain a short-term view of a practice’s value. Although this method does not determine a business’s intrinsic worth, it does calculate what a buyer could afford to pay for the business while still achieving a required rate of return on their investment. The "leverage" in an LBO refers to the significant amount of debt used to finance the purchase of the company, which amplifies the potential returns for the equity investor.
When people apply the LBO model, they work backward from their desired outcomes. Assumptions are made on the capital structure of the deal—how much debt versus how much equity will fund the acquisition. The model may also project the practice's financial performance over a holding period, which can span up to seven years.
These projections can help determine how much of the initial acquisition debt they can reduce using the practice’s cash flows. The goal for the financial sponsor is to utilize the company's own earnings to service and reduce its debt, thereby increasing the business's equity value over time.
At the end of the holding period, the model assumes the financial sponsor will sell the business. The exit value is typically calculated by applying a multiple (like an EBITDA multiple) to the company's projected earnings at the time of sale.
This exit multiple is often assumed to be similar to the multiple paid at the time of acquisition. After determining the exit enterprise value, any remaining debt is subtracted to calculate the final equity value. The sponsor then calculates their return on investment (ROI) by comparing the initial equity contribution to the final equity proceeds received upon exit.
The key output of an LBO analysis is not a single valuation figure, but rather a range of potential purchase prices that would allow a financial buyer to meet their target ROI. For example, if a private equity firm wants to acquire a practice, use its cash flow to pay down debt, and sell it in five years for a price that generates a 25 percent annual return, the LBO model will show the maximum price they could pay today to achieve that goal. Therefore, it's a valuation based on deal structure and financial engineering rather than the standalone intrinsic value of the business itself.
Unlike its short-term counterpart, the DCF method takes a longer-term view. It determines a business's current value based on the total amount of cash it is projected to generate in the future.
To perform a DCF valuation, you must first forecast a practice's unlevered free cash flow over a specific period, typically five to ten years. Unlevered free cash flow represents the cash a business produces before accounting for any debt obligations. This involves projecting revenues, operating expenses, taxes, and necessary capital expenditures.
When considering the purchase of a practice, one must take into account projected patient or client growth, billing rates, staff salaries, rent, and investments in new equipment or software. It’s a detailed, ground-up process that requires a solid understanding of the business’s operations and market dynamics.
After projecting these future cash flows, you must "discount" them back to their present value. This is a critical step that accounts for the time value of money—the idea that a dollar today is worth more than a dollar tomorrow due to its potential earning capacity. The rate used to discount these future cash flows is the weighted average cost of capital (WACC).
The WACC represents the blended cost of a company's capital from both equity and debt sources. A higher WACC, indicating higher risk or a higher cost of financing, will result in a lower present value of those future cash flows, and therefore a lower valuation for the practice.
Finally, a DCF analysis includes a "terminal value." Since a business is expected to operate beyond the explicit forecast period, the terminal value calculates the value of the practice for all the years after the projection window.
You can then add the terminal value to your projected cash flows to learn the value of the business. Afterward, you can subtract net debt to find the equity value.
After gaining a better understanding of the two valuation methods, it’s time to determine which is better for you. This may depend primarily on your specific acquisition strategy and financial structure. For example, the DCF can answer the fundamental question, "Based on the cash this practice can generate on its own, what is it truly worth?" This approach provides an operationally focused valuation that serves as a logical baseline for your offer, preventing you from overpaying based on market hype.
However, if you plan to finance the acquisition with substantial leverage—a common strategy for private equity investors and individual buyers alike—the LBO model is indispensable. It forces you to scrutinize the practice's ability to service debt from its cash flows and calculates a purchase price based on financial structure and desired returns.
Ultimately, using either approach enables you to assess a practice from an operational and financial perspective. You will boost your negotiating power and improve your ability to anticipate potential risks and returns over the long term. With either the DCF or LBO method, you can be more informed and confident as you move toward practice ownership.
Buyers can also further equip themselves with the help of the team at Private Practice Transitions. Our experienced associates possess the specialized knowledge to provide opinion of value services. Call us today for assistance in making the best financial decisions for your future.