by Ann Colborne
This article draws on some recent research funded jointly by Bristol Polytechnic and the Royal Institution of Chartered Surveyors into the profits method(1). It seeks to show that the method, far from being one that can be dismissed as marginal, is widely used for the valuation of capital assets and is one displaying the same problems of analysis and application that appear in the investment method of valuation. It is a legitimate area of expertise for the surveyor, but needs to be subject to rigorous analysis, particularly in respect of the methodology of capitalisation by years’ purchase.
Any standard property text will mention the profits method. Illustration of its use will usually be confined to a short introductory example, plus perhaps more detailed examples of the valuation of public houses and/or hotels — possibly for rating purposes.
What is perhaps generally unrecognised is the large number of surveyors practising the valuation of property assets on the profits method basis and, as well as hotels and pubs, valuing shops, post offices, garages, small businesses, car parks, garden centres and those giants of today’s social climate, recreational facilities.
All these assets are valued on the principle that their capital values are derived from the profits of the business occupying them. Thus a fairly standard accepted format for valuation is:
This capital value might be applied to the valuation of an asset of a business for accounts purposes, to the valuation for sale or purchase of a business with its assets, or for the price paid for an asset for its use in a business.
Capital value
The capital value arrived at by the simplistic formula above can be viewed in two ways.
Current thinking mainly views it as the lock-stock-and-barrel value of the business with all its working assets, including property. This is supported by the nature of current transactions, particularly of smaller businesses but also of hotels and leisure facilities on this basis.
The alternative view is that this represents the value of the goodwill, of super profit, of the business to which must be added the value or worth of the fixed assets of the business. This view has led to the confusion in terminology between “going concern” and “goodwill” valuations. Strictly, the former is the going concern valuation, and the latter the goodwill valuation. The goodwill approach used to be very widely accepted and it was not unusual to see in the accounts of a company, on the balance sheet:
There is no hard and fast rule as to which is correct. However, the goodwill approach holds an implication that the fixed assets have a continuing value outside the business. This might be true in the case of a shop, for instance, whereas a swimming pool probably has a value only as a part of the business complex containing it — there is no alternative market value.
In recent years accountants and their investors have realised that there is a problem, and have dealt with it by requiring that the goodwill element be recovered in the profits of the business, “written down” in jargon, over the first three years. This reduces the value of the fixed assets (unless they increase in value and can be revalued) to £400,000 in our example.
The importance of this to the business investor, particularly in a quoted company, is that the £50,000 being used to write off the goodwill is not available to be paid out in the form of dividends; in effect the money must be ploughed back into the company. The underlying asset value of the company is also reduced by the amount of the goodwill.
It follows that it is often in the interests of a company not to report the goodwill in the accounts. The alternative is to include the sum in the value of the fixed assets. The valuer’s role can therefore be quite important in the creative accounting process. Valuers need to consider to what extent they can accept the simpler lock-stock-and-barrel basis as including the value of the property and thus be prepared to let the value of the property be the residual figure in this. It would not seem to be a problem where the asset could be expected to be sold again, as part of a business, at the same price. The problem arises where the property is of a type where an alternative valuation, perhaps by the investment method, produces a lower sum — a shop, for example, where the goodwill element might be called key money.
Adjusted net profit
The adjusted net profit is normally considered to be the amount of profit that could be expected to be achieved from year to year after all the running expenses have been deducted. Some of the deductions will vary, as is shown in Example 1 if a goodwill rather than going concern approach is taken. In as much as goodwill valuations separately value the property and other fixed assets, then interest on capital/rental values employed in the business is separately deducted.
The treatment of depreciation is worthy of further consideration. Valuers would usually not make a deduction for any depreciation of assets, similar to their approach when valuing on the investment method, the yield being adjusted to allow for the life of the asset being valued. In practice the net profit figure is not purely return on capital and reward for effort — it also represents partly money available for the replacement of the assets in due course (the sinking, or replacement of capital, fund).
The adjusted net profit is the reward for investment of capital — it is not the salary for working in the business. A small business usually requires to pay the owner for his labour and strictly this sum should be deducted. In fact the market does not necessarily deduct this (the Perezic v Bristol(2) argument), but we should affect the price paid if no deduction is made for salary by adjusting the yield. Often this is not apparent — the price might be right in market terms, but that does not always make it sensible!
Another item of contention is the inclusion of head office overheads — a charge which is not directly related to the business in the premises, but more to the running of a large concern. The example below shows a typical deduction of 2% to 3% gross profit or sales. This sounds fairly insignificant until you recognise that it is 8% of adjusted net profit.
Fortunately most businesses in the market for the larger properties would require this sort of deduction. A smaller firm, though, would be in a position to undercut — given equality of all other outgoings and yield requirements. This is the type of factor which influences the price paid in management buy-outs of businesses.
Future changes in income flow are traditionally dealt with by adjustment to the years’ purchase, rather than by a discounted cash flow approach seeking to show these changes explicitly. Increasing use is being made of DCF, particularly in the decision-making, rather than pure valuation process, examples being the extension to a hotel, key money for a shop, and new-build. The rate of incorporation of this into the valuer’s repertoire is at about the same rate as for investment method valuations! While its use does not make analysis of market transactions any easier, it does make the assumptions clear.
Yield
What is YP = 3?, YP in perpetuity at 33%?, YP 5 years at 20%?, YP 4 years at 10%? Does it matter? The answer has to be that the figure 3 (or whatever) means different things at different times and in differing circumstances. One of the problems associated with the simple YP approach to valuation is to make clear the analysis of yield, given the range of assumptions under which it is created.
The capitalisation of the net profit should be carried out at a yield which reflects the risk of the income flow. It is generally held that income from a business is more risky than income from a property investment. This is not essential, but it is likely to be so because of the residual nature of the profit. The rental investment income is a contractual receipt, whereas profit is a top slice of the gross income after deduction of all other outgoings. The risk of receiving profit depends on the relationships between income and fixed and variable costs, as well as market conditions.
Another factor is the acceptance that within the profit element of a business is the depreciation, or replacement fund for the fixed assets. It is now well understood that inherent in the yield applied to property valuation is an allowance for a small element of the income to be used for replacement of capital, much as in the explicit allowance of a sinking fund in a traditional leasehold valuation. In the case of a business containing assets other than the property, this sum is likely to be replacing fixed assets over a shorter time-scale, ie the period over which the investment can continue to earn a profit is not perpetuity. An allowance for depreciation in adjusting the net profit may help to overcome this, but it must be remembered that the cost of replacement is not the historic figure which is being depreciated. (The sinking fund problem is not unique to leasehold property assets.)
The yield used will therefore partly depend on the amount of capital in the business which is tied up in the property as opposed to other fixed assets. Valuers must be careful to distinguish between those elements of a property being purchased as a part of a business asset and the price paid for the residential element. Country pub prices, for instance, indicate that the prices achievable from residential owner-occupiers as opposed to business users are not comparable.
Yields used will therefore vary from the very low ones derived from the analysis of such sales, which are largely meaningless except for direct comparison, to the very high apparent yields that we might associate with compulsory purchase valuations which are often distorted by the presence of the one-man business.
Business returns vary between 5% and 60%. The latter is necessary where the business is one with high reinvestment costs such as the computer software industry: the lower yield might be appropriate where a large amount of the worth of the business is associated with the property it occupies.
These returns, however, might be an average of all assets of companies (some of whom will own very little property), and additionally might reflect the returns on the historic cost of fixed assets. They are therefore not helpful to the valuer in arriving at a fair view. On the other hand, investment property yields are similarly inappropriate because of the increased level of security obtainable from the contractual income. Current practice depends almost entirely on market comparables and is causing concern in some industries. There is an urgent need to apply some of the work being undertaken in the evaluation of risk to these valuations.
NB Taxation
Valuers should be aware that many decisions are influenced by taxation considerations. No allowance has been made for this in any of the above examples.
(1) The Profits Method of Valuation: Interim report and discussion paper, by A Colborne and L Mawby, is available from the Research Unit, Department of Surveying, Bristol Polytechnic, £2.
(2) Perezic v Bristol Corporation (1955) 5 P&CR 237
