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Chapter Four, Part Two

Nyla had carried one question around all week. At the end of their last visit, Dr. Avery, DNP had asked what you would need to know before deciding whether it was smart for a company to keep its profit, and Nyla had written the question at the top of a clean page and added three guesses underneath.

She opened the notebook before Dr. Avery, DNP finished closing the office door. The fish drifted behind the desk, and the valuation report sat beside her, its edges softened from a week of handling.

"Last time I left you with a question," Dr. Avery, DNP said. "What did you work out?"

"I'd need to know where the growth comes from," Nyla said. "If a company grows, the money had to go somewhere. So it keeps some of its profit and puts it to work."

"That's right. The share it keeps is called the plowback ratio, and the share it pays out is the payout ratio. Growth equals the plowback ratio times ROE, return on equity, which is the profit the kept money earns as a percentage of what was put in. A company that pays out 100 percent has zero plowback, so zero growth, because zero times anything is zero."

She tapped the page. "Here's the cleanest version, because it explains how a stock is priced. A no-growth company that pays out all its earnings is worth next year's earnings per share divided by r. Say earnings are $5 a share and r is 10 percent. That's $50. Now suppose the company keeps earnings to fund projects that earn more than 10 percent. Those projects have positive net present value, and their combined value is called the present value of growth opportunities, PVGO. If PVGO is $15, the stock is worth $50 plus $15, which is $65. But if the kept money earned exactly 10 percent, PVGO would be zero and the stock would stay at $50, even though earnings kept growing."

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"So growth isn't automatically valuable," Nyla said.

"Hold that thought. Investors call a company that pays out most of its profit an income stock, with a high dividend yield and a value that comes mostly from its existing earnings. They call one that keeps most of its profit a growth stock, with a low yield, a high plowback ratio, and a value that comes mostly from growth opportunities. Neither is better. The question is always whether the kept money earns enough. And now it's our turn. Mahogany expects to earn $200,000 next year after every expense. I can pay all of it out to myself as owner distributions, or keep 40 percent to build a hair and scalp program, with a dedicated room, equipment, and training for another provider."

Nyla ran the baseline herself. "Pay everything out, no growth. $200,000 over 10 percent. That's $2 million."

"$2 million. I use 10 percent because one small practice carries more risk than the stocks I compared on the laser, where 8 percent was right. Now keep 40 percent. The distribution drops to $120,000, and suppose the program earns 15 percent on the money kept."

"0.4 times 0.15. That's 6 percent growth." Nyla wrote it down. "$120,000 over 0.10 minus 0.06. $120,000 over 0.04. $3 million."

"$1 million more than the baseline, and that extra million is the program's PVGO. Now watch what happens when I change only the ROE. If the program earns exactly 10 percent, growth is 4 percent and the value is $120,000 over 0.06, which is $2 million, no better than paying everything out. If it earns 6 percent, growth is 2.4 percent and the value drops to about $1.58 million, worse than paying everything out. Keeping profit creates value only when ROE is greater than r. At the same rate, it grows the practice while the value stays flat. Below it, retaining profit destroys wealth. The same test applies to buying a $60,000 laser or opening a second location with the profit I keep."

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"How do you know it will earn 15?"

"I don't. It's a forecast, so I give it a range, the way that study gave one. A number and how sure we are about it." Dr. Avery, DNP smiled. "And 15 percent can't last. If a hair and scalp program works, other practices will open one, and returns will fall. A steady-growth formula assumes the same growth forever, and that rarely holds in a hot sector, so I use a two-stage model. Suppose the program grows at 6 percent for three years, then competition pushes ROE down to 10 percent, which makes growth 4 percent from year four on."

"What are the steps?"

"Four. First, forecast the distributions in the fast stage and discount each one at 10 percent. Year one is $120,000, year two is $127,200, and year three is $134,832. Together they're worth about $316,000 today. Second, find the horizon value, what the practice is worth at the end of year three once growth settles. Year four's distribution is about $140,000, so the steady formula gives about $2.34 million. Third, discount that horizon value back three years, which gives about $1.76 million. Fourth, add the two pieces."

Nyla added them. "$2.07 million."

"Not $3 million. The $3 million answer assumed 15 percent forever, and the version with competition is about $2.07 million. Still above the $2 million baseline, but only by about $70,000."

Nyla looked up. "Wait. You keep saying dividends. But Mahogany doesn't pay dividends. You take a draw."

"Good catch, and this is the last piece. To value a whole business instead of a share, I use free cash flow, the actual spendable cash left after the practice pays for what it needs to operate and grow. Free cash flow equals operating cash flow minus capital expenditures, the cash spent on physical assets. Picture a medspa that generates $500,000 in operating cash flow and spends $60,000 on a state-of-the-art laser. Its free cash flow is $440,000. Net income is a weaker guide, because it includes non-cash expenses like depreciation, which spreads an asset's cost over many years on paper, and it ignores the big upfront purchase when the check is written."

"So the $440,000 is what's really on the table."

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"For the owners and everyone who funds the practice, yes. The valuation formula is the same as before. Discount each year's free cash flow through year H, then add the horizon value discounted back the same number of years. For Mahogany, with depreciation set aside to keep the math clean, operating cash flow is $200,000 and I spend $80,000 of it on the program, so free cash flow is $120,000, the same figures as the distributions. That's why the answer is the same $2.07 million."

"And the horizon value?"

"There are two common ways to set it. One is the steady-growth formula we just used, free cash flow next year over r minus g. The other is a market multiple. Buyers of practices often value a business at a multiple of EBITDA, earnings before interest, taxes, depreciation, and amortization. For a practice this size, about 5 to 8 times is a common range, though large platforms sell for far more. If Mahogany's EBITDA in year three were $350,000, 5 to 8 times gives $1.75 million to $2.8 million. Our $2.34 million sits inside that range, and two methods that agree make me trust the number more."

Nyla sat back. "So do you build it?"

"I build the first phase," Dr. Avery, DNP said. "The room and the training, funded from profit I keep this year. After 12 months I compare the real return to 10 percent before I keep another dollar for it. The forecast gets one year to prove itself."

She turned the notebook toward Nyla. "Here's your page for today. Write what holds up."

Nyla wrote seven lines, one under the other, in her own handwriting. A share returns dividends plus price gains. A share is worth the present value of every dividend it will ever pay. For steady growth, price is next year's dividend over r minus g, and growth is plowback times ROE. Keeping profit adds value only when ROE beats r. A fast-growth business is valued in two stages, with a discounted horizon value. A whole business is valued on free cash flow, not accounting profit. Match nominal cash flows to nominal rates, and real to real.

Under the seven lines she wrote one more, from the exam room. The number. The range. What we don't know.

"That last line is the habit," Dr. Avery, DNP said. "In the exam room it protects the patient, and in the practice it protects the business. Say the number, say the range, say what you don't know, and then act on what's left."

Nyla closed the notebook, the fish still swimming across the cover. "You said 10 percent a lot today. Where does it come from?"

"That," Dr. Avery, DNP said, "is next time's lesson. Go home and see if you can defend it."

Nyla turned to a clean page and wrote the question at the top.

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This installment is dedicated to my mom and my uncle, both breast cancer survivors. You can hear them share their story on The Melanin Initiative Podcast.

Behind this chapter: The second half of the finance arc, covering the plowback ratio, return on equity versus the cost of capital, the no-growth baseline, present value of growth opportunities, income versus growth stocks, two-stage valuation with a horizon value, and free cash flow with enterprise valuation, comes from the common stock valuation framework in Brealey and Myers' Principles of Corporate Finance. It's applied here to a practice decision rather than a public stock, with story numbers, in keeping with this year's whitepaper, Financial Literacy as a Clinical Competency. The habit Dr. Avery, DNP closes with comes from Part One's study, Coogan PF et al., "Hair product use and breast cancer incidence in the Black Women's Health Study," Carcinogenesis, 2021. The mentorship model comes from Dr. Kimberly Madison's, DNP, book, Nursing Aesthetics: An Introductory Guide for Nurse Practitioners & Entrepreneurs.

Nyla just watched a growth plan get tested before it was funded, and real students who want to be a dermatologists like her are testing their own plans too. Clarence Sams, MS4 at Charles R. Drew University, shares his on The Melanin Initiative's "Becoming a Physician" series, and Ijenna Adibe, a senior at Howard University, shares hers too. Wherever you're starting from, the door is already open.

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About the Author

Dr. Kimberly Madison, DNP, AGPCNP-BC, WCC, is a Board-Certified, Doctorally-prepared Nurse Practitioner, educator, researcher, and author dedicated to advancing dermatology nursing education with an emphasis on skin of color, business acumen, and digital literacy. She is the founder of Mahogany Dermatology Nursing | Education | Research™ and the Alliance of Cosmetic Nurse Practitioners™, the first dermatology nursing organization in the country built at the intersection of clinical excellence, skin of color care, and financial literacy for nurses. A selected participant in the Harvard Business School Foundry Mindset Bootcamp, Dr. Madison continues to sharpen the entrepreneurial infrastructure behind her mission. Through peer-reviewed research, published books, and a growing community of nurse entrepreneurs, Dr. Madison is building the infrastructure that makes this profession sustainable for the people who choose it.

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