Profits Method

Introduction
• 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
– 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
Business
• Property • Background and History…..
• Identify the extent of the property to be valued, • Customer profile
usually includes • Opening Hours and Peak trading periods
– all plant and machinery
• Licensing
– fixtures
– furniture • Environmental Health
– furnishings • Fire Authority
– fittings • Rating
– equipment • Agreements
– transferable goodwill • Brewery Ties
• existing and renewable licences
• permits
• consents Competition
• registrations • Assess level and style of competition
• certificates • Is the business local, regional, national?
• advanced bookings
• order books • What degree of competition is there?
– freeholds often include trade inventory • Is the presence of other operators beneficial?
– development or redevelopment potential • This will affect both the profitability and the yield
• Inspect to identify to be used
– 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
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
– VAT returns
– Management accounts
– Weekly sales records
– Stocktaking records
– Purchase invoices
– Fee levels and occupancy records
Step 3 – Analyse Information
• Income
• Gross Profit - sales value less costs of purchase
• Gross yield – gross profit expressed as a %, e.g.
– 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:
• 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
• 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
• 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.
– 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
• What tricks can be used by a vendor to adjust levels of trade shown in
accounts?
– Cash sales and purchases
– Two bank accounts
– Churning
• 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
• When does the profits method begin to break down?
– purposely under traded business
– extraordinary levels of trade achieved
– excessive levels of personal goodwill
– new asset classes – relationship to underlying property unknown
• 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

10
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: Capitalised Earnings:

or
Take rent at 50% £ 250,000 Net Operating Profit: £ 500,000
x YP perp @ 10% 10 x YP perp @ 20% 5
£2,500,000 Market Value of Hotel £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 [1] With two owners fully
Adjusted Net Profit 270,000* involved, we are of the opinion
*prior to taxation, depreciation, Directors' remuneration and that the wages liability can be
finance costs contained at around 40% of net
Fair Maintainable Profit £545,000 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)