Profits Method
Introduction
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Used to value properties typically sold as part of a business
(properties equipped as operational entities) so it is difficult to obtain
evidence of property prices and rents
Value is determined having regard to estimated future trading
potential
Method involves estimating the profitability of the business and
isolating a portion of profit available as rent
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Calculate the total potential income then deduct the working expenses
Potential net profit adjusted to reflect the trading of a reasonably
efficient operator
The resulting adjusted net profit is divided between the tenant and the
landlord (the landlords “share” being equivalent to the rental value)
The rent can be converted to a capital value if required
It may be possible to make comparisons with similar trades on a
wider geographical scale, perhaps examining profit made per hotel
bedroom or nightclub floor
Profits method overview
Gross earnings / turnover
Less cost of sales (e.g. food, drink, etc.)
= Gross profit
Less working expenses (e.g. wages, etc.)
= Net profit
Less remuneration to operator
Less interest on capital invested capitalised at cost of
borrowing
= Adjusted net profit
Then either:
1. Dual capitalisation approach: Apportion adjusted net annual profit between rent
(to landlord) and profit (to tenant operator), then capitalise this notional ‘annual
rent’
2. or simply capitalised profit at a suitable YP to produce a capital value directly
Step 1 – State Assumptions
• Business makes a profit
• Rent is a surplus paid out of this profit
• Current trading activity represents the optimum use
• The business is efficiently run
• Size of proprietor team, e.g. 2 persons for licensed premises
Step 2 – Collect Information
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Property
Identify the extent of the property to be valued,
usually includes
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all plant and machinery
fixtures
furniture
furnishings
fittings
equipment
transferable goodwill
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existing and renewable licences
permits
consents
registrations
certificates
advanced bookings
order books
freeholds often include trade inventory
development or redevelopment potential
Inspect to identify
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Sources and amounts of income and expenditure
Any unusual items and conditions
Efficiency of layout
Level of comfort afforded in trading areas
Number and nature of letting rooms
Quality of owner’s accommodation
External facilities
Repair
Business
• Background and History…..
• Customer profile
• Opening Hours and Peak trading periods
• Licensing
• Environmental Health
• Fire Authority
• Rating
• Agreements
• Brewery Ties
Competition
• Assess level and style of competition
• Is the business local, regional, national?
• What degree of competition is there?
• Is the presence of other operators beneficial?
• This will affect both the profitability and the yield
to be used
Step 2 – Business Finance Information
• Company’s annual accounts (or receipts)
– Previous three to five years
– Accounts include all sorts of costs that affect the net
profit differently
• Other sources of business financial data
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VAT returns
Management accounts
Weekly sales records
Stocktaking records
Purchase invoices
Fee levels and occupancy records
Step 3 – Analyse Information
• Income
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Gross Profit - sales value less costs of purchase
Gross yield – gross profit expressed as a %, e.g.
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Pint of beer £2.50
Cost of beer £1.00
Gross Profit £1.50
Gross Yield £1.50/£2.50*100 = 60%
Expected gross yields:
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Wet sales – tied 45%
Wet sales – free of tie 55-60%
Food sales – 55-60%
Accommodation – 90-95%
Net Profit – the profit after all other business expenses
Net yield – the net profit expressed as a percentage
Tarriffs:
– Bar and wine tariff – compare to local area, last price increase
– Catering tariff
– Accommodation tariff – any discounting, occupancy levels, average room rate
Step 3 – Analyse Information
• Expenditure
– Includes
• Wages: analyse wages as a % of fee income, e.g.
– Wet sales pub: 15% of net turnover
– Restaurant: 25% of net turnover
– Hotel: 35-40% of net turnover
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Repairs
Insurance
Rates
Running costs
Marketing
Printing and stationery
Depreciation allowance, e.g. sinking fund
Any personal capital invested in the business
– Excludes
• Rent (that’s what we are estimating!)
• Mortgage payments or interest on capital invested
Step 4 – Derive Adjusted Net Profit
• Accounts are a snapshot, adjusted net profit is a trend
• EBITDA plus proprietors drawings and finance costs is adjusted net
profit
• Identify a fair maintainable profit from a reasonable operator
– Consider
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• whether the business has more than one property
• whether remuneration of the proprietor of an owner-occupied business is
included
• effect of any additional revenue such as tips in the case of licensed premises
Those that are individual for the particular proprietors should be excluded, e.g.
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own consumption (proprietors’ drawings, personal pension costs, excess transport costs, guard
dog expenses)
finance arrangements (HP, leasing costs, loan interest, rentals, interest paid and received)
calculations that derive from the balance sheet (depreciation, amortisation, profit/loss on sale of
assets)
Tricks of the trade
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What tricks can be used by a vendor to adjust levels of trade shown in
accounts?
– Cash sales and purchases
– Two bank accounts
– Churning
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Where the level of trade has been distorted by the vendor, other standard
ratios will be thrown out, e.g.
– wages percentages
– gross yields
– net yields
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When does the profits method begin to break down?
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The underlying alternative use may exceed the value of the business
In all of these circumstances greater levels of adjustment are required from the
valuer in going from the accounts to generating the Fair Maintainable Trade for
valuation purposes
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purposely under traded business
extraordinary levels of trade achieved
excessive levels of personal goodwill
new asset classes – relationship to underlying property unknown
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Step 5 - Determine a capital
value of the property
• Do not include
– personal goodwill
– consumable stock
• Two methods
– Capitalised earnings
• Capitalise EBITDA at a suitable yield derived from market evidence or
– Dual capitalisation
• Split EBIDTA between
– business profit
– rent
• Capitalise notional rent
Application of method:
simple example
Analysis of accounts:
• Gross takings
2,340,000
• Less cost of Sales
650,000
• Gross Trading Profit
1,690,000
• Less running Expenses
1,100,000
• Net Profit
590,000
• Less int. on T’s capital @ 10%
50,000
• Less ASF for contents
40,000
• Net Operating Profit
500,000
Application of method – simple example
Valuation:
Dual Capitalisation:
Take rent at 50%
x YP perp @ 10%
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£ 250,000
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£2,500,000
Capitalised Earnings:
Net Operating Profit:
x YP perp @ 20%
Market Value of Hotel
£ 500,000
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£2,500,000
More detail...
Net Sales
(weekly ave = 52,740)
2,750,000
Gross Profit
2,200,000
Less Operating Costs
Wages and Salaries [1]
1,375,000
Rates, Water, Environmental Charges
90,000
Heating and Lighting
65,000
Repairs and Maintenance
100,000
Insurance
55,000
Telephone
15,000
Printing, Postage, Stationery
30,000
Promotion
55,000
Accountancy and Professional Fees
15,000
Transport
25,000
Laundry, Cleaning, Linen Hire
45,000
Entertainment
20,000
Credit and Charge Card Commissions
18,000
Sundries (including Licence Fees)
22,000
Costs Total
1,930,000
Adjusted Net Profit
270,000*
*prior to taxation, depreciation, Directors' remuneration and
finance costs
Fair Maintainable Profit
£545,000
[1] With two owners fully
involved, we are of the opinion
that the wages liability can be
contained at around 40% of net
sales. So reduce costs by
£275,000, thus increase ANP and
FMT...
Key Points
• Valuation of specialised trading properties requires
specialist skill
• Heavy reliance on accounts and other financial information
about the business and also reliance on expertise to value
goodwill element of the business
• Attention should be focused on
– Adjustment of the costs to bring net profit back to a point where
there is no regard to the individual operator
– The selection of an appropriate capitalisation rate (yield) or
capitalisation factor (YP)