Question:
Expert Response
I am often asked what's the difference between value and price? Surely, the value is what someone is willing to pay for the business! Or is it? And, does the difference justify the investment or matter?
While the pharmacy market is relatively efficient at setting realistic purchase prices for pharmacy, some areas of the market are poorly managed. In these areas, the market is not efficient. Clients are often confused when a valuation figure is far less than the asking price or price paid. As a result of favourable demand conditions, the current prevailing trend is that the seller's asking price often includes an 'acquisition premium.'
Is the premium worthwhile if valuations accurately assess the return on investment? It is best to firstly understand how a pharmacy is valued.
Practical Issues
Pharmacy valuations are generally based on the capitalisation of estimated maintainable earnings.
This is not a return on pharmacy investment.
The appropriate capitalisation rate used in the valuation process is determined by prevailing market rates, marketability/desirability of the site, risk, and general economic conditions. Current Australian pharmacy capitalisation rates range between 15% - 22% with market demand and supply changing the implied rate of return.
Capitalisation Rate Explained
The capitalisation rate is the yield rate implied in the Purchase Price of the pharmacy given the Adjusted Net Profit for valuation purposes. It is obtained from the following formula:
Capitalisation Rate = Adjusted Net Profit for Valuation Purposes / Purchase Price
This is commonly referred to by the pharmacy business sales brokers as ROI" (Return on Investment).
The capitalisation rate is the percentage the Adjusted Net Profit for Valuation purposes is divided by to equal the purchase price for the pharmacy. For example, if a pharmacy is sold for $1,000,000 and has an Adjusted Net Profit for Valuation purposes of $170,000, the capitalisation rate is 17%.
Return on Investment
Value is calculated such that the "net profit" (as adjusted) provides a yield on the total purchase price of the business (stock, fixtures & fittings, goodwill).
This yield rate ignores a vital component of the return on investment which pharmacy has received to date: capital gains!
What is the return on investment for a property investment? Return would normally include Rent (rental yield) and Capital Gains. Similarly, for share market investments, the return would normally include Dividends (dividend yield) and Capital Gains.
It's the same for pharmacy. Return comprises Capitalisation Rate (yield) and Growth (Capital Gain).
Rate of Return
The capitalisation rate varies throughout Australia and each pharmacy is valued as a stand alone unit. In essence, a single rate cannot be applied to all pharmacies. The Melbourne Metropolitan average capitalisation rate is approximately 17%. However, not every Melbourne pharmacy would be valued at this rate. The capitalisation rate employed for each pharmacy is adjusted for direct and indirect factors which impact on the desirability of the pharmacy.
These may include the following:
- Gross Profit margins and financial performance to date
- Growth and outlook
- Lease arrangements and rent (security of tenure)
- Pharmacy Characteristics (location, product mix, general presentation etc.)
- Prevailing Interest rates plus a factor for risk
Rates of return also vary and change over time. Variance may be a result of market demand, pharmacy location or aspects of overall desirability, as well as general performance of pharmacy compared to other investment areas and the economy.
Accounting Adjustments
In the calculation of the final value, an adjusted net profit figure is used. This figure is created through making adjustments to the reported accounting net profit. The adjustments recognise business costs (inc. owner's time) and remove tax-based and asset related transactions.
- Owner's hours worked are adjusted by taking actual hours worked in the business at an appropriate rate
- Lease items, depreciation, interest and non-business items are also added back to net profit
Adjusted Net Profit for valuation purposes calculation: an example
| Notes | Example | |
| Accounting Net Profit | 1 | $120,000 |
| Add back non-business items or capital-related items, that is, depreciation, leases, non-continuing expenses and so on | 2 | $25,000 |
| Business return | 3 | $145,000 |
| Less owner's salary (for actual hours worked) | 4 | -$45,000 |
| Adjusted net profit for valuation purposes | 5 | $100,000 |
Notes:
- Accounting Net Profit may be based upon the tax-reported figures, the average of the past three years' figures or any combination of these.
- Non-Business adjustments are made to ensure the buyer is evaluating the business on the basis of the expenses which will continue after purchase.Depreciation and non-cash items are also removed as we wish to derive the business return and a total business purchase price. Assets(stock & fixtures) are deducted from the total price to arrive at the "goodwill" figure.
- Business return should represent the future maintainable stream of income.
- Owner's time is now accounted for. This represents a reasonable salary for the type and hours of work actually worked.
- Adjusted net profit for valuation purposes is the final product of this approach.
To calculate the value of the business or total purchase price, the adjusted net profit for valuation purposes is the risk-adjusted rate of return (appropriate rate of return for the pharmacy):
Total Purchase Price = Adjusted Net Profit for Valuation Purposes / Capitalisation Rate
Effective Rates of Return
In reality the capitalisation rate for the most sought after pharmacies may calculate to be as low as 15%. Geographically, these occur only in Victorian or NSW metropolitan areas. Even though the capitalisation rate is low at 15%, the effective return on investment will be much higher. The reason for this is that Adjusted Net Profit (ANP) can be considered as a dividend yield and to obtain the effective rate of return, capital gains need to also be accounted for. Capital gains come in the form of changes in the value of the pharmacy as a result of growth.
By treating ANP as a dividend yield in the same manner that a share market investment, the result is a much larger return. The following table lists the effective rates of return when both capitalisation rates and growth rates are taken into account.
Growth Rate
| Capitalisation Rate | 0% | 5% | 10% | 15% | 20% |
| 15% | 15.0% | 21.5% | 28.1% | 34.7% | 41.4% |
| 16% | 16.0% | 22.6% | 29.2% | 35.8% | 42.5% |
| 17% | 17.0% | 23.6% | 30.2% | 36.9% | 43.6% |
| 18% | 18.0% | 24.6% | 31.3% | 38.0% | 44.8% |
| 19% | 19.0% | 25.7% | 32.4% | 39.1% | 45.9% |
| 20% | 20.0% | 26.7% | 33.4% | 40.2% | 47.1% |
From the table we see that a Capitalisation Rate of 17% where 5% growth is being achieved actually provides an effective rate of return of 23.6% compounded per annum.
Quick Survey
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