Pharmacy Returns - are pharmacy returns reasonable

PBS Reforms combined with the impact of the recent credit crunch have driven many pharmacists to ask the question - should the prices being paid for pharmacies come down? In the context of the current economic climate, many expect that returns should increase to reflect the increasing uncertainty and/or risks about pharmacy. But is this the case?

Pharmacy returns

Pharmacy business sales brokers generally refer to the capitalisation rate as the return on investment. But is it?

Like many investments, what brokers generally refer to as 'Return on Investment' (ROI) is yield. For property investments, it is rental yield (i.e. rent ÷ purchase price of property = rent yield). For shares, the dividend yield (i.e. dividends per share ÷ share price = dividend yield). For all three, pharmacy, property, and shares, these calculations ignore capital gains!

Capitalisation Rates

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:

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%.

The capitalisation rate for a pharmacy should reflect its risk and uncertainty. The actual capitalisation rate is specific to the particular pharmacy and is a function of:

• Risk (economic, financial, internal, size, variability)
• Location (rural vs. metropolitan)
• Financial performance
• Competition
• Industry outlook

Pharmacy Return - Rate of Return

Return on investment comprises the two forms of return - yield per annum and capital gains.

Capitalisation rates measure the income as a percentage of purchase price or value. Most investment decisions are made taking account of both the income and capital appreciation which occurs from ownership.

The graph below highlights the Rate of Return - income plus capital gains; since 1972. (the blue line is the 5 year moving average)

It obvious that Returns have declined.

But the question is are they too low? Are pharmacy prices too high (given the income)?

Should pharmacy returns be higher?

Many pharmacists and financial analysts are asking whether in the light of PBS reforms and the credit crisis, should pharmacy prices decline or, alternatively, should pharmacy returns increase to reflect the increased risks related to pharmacy?

Pharmacy returns and prices are related to a number of factors including:

• the risks associated with pharmacy;
• cost of capital (finance); and
• alternative use of capital.

Risks

Pharmacy risks are always a question of perspective. It is often the case that many pharmacists see the future as bleak and full of risks.

While the past was the 'good old days' the future appears tougher and harder.

Finance & Cost of Capital

In the context of increasing interest rates, economic theory would suggest that returns would increase and pharmacy values would decline.

The following graph highlights the relationship between Pharmacy Rate of Return (yield and capital gains) [RoR - red line] to Pharmacy Finance Rates [Finance Rate - blue line].

The data suggests that there is a very limited relationship between interest rates and pharmacy returns.

Economic theory would suggest that increases in interest rates would lead to declines in pharmacy value or increases in required rates of return. However, the evidence does not provide any evidence of the relationship between cost of capital and returns.

Alternative use of capital

A major factor driving both the prices/value and returns is the alternative use of capital. If you sell, where can you invest and what are the returns on investment?

The following graph illustrates the 5 year average Return on Investment (income and capital gains) across a range of investment classes. While it is obvious pharmacy returns are generally higher than other investment classes, the return is:

1. declining; and
2. reflects the underlying risk and liquidity of pharmacy.

Over the period, pharmacy returns have been consistently above alternative investment classes. However, it is also apparent that pharmacy returns are declining. Over the period 1985 to 2007, the average and median rates of return are listed in the table below.

Clearly Property and Shares have declined dramatically since 2007 and these calculations were made! However, pharmacy has also gone through further declines.