# Profits Method. Introduction Used to value properties typically sold as part of a business (properties equipped as operational entities) so it is difficult.

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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 Property Identify the extent of the property to be valued, usually includes –all plant and machinery –fixtures –furniture –furnishings –fittings –equipment –transferable goodwill existing and renewable licences permits consents registrations certificates advanced bookings order books –freeholds often include trade inventory –development or redevelopment potential Inspect to identify –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 –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)

10 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

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 Gross takings2,340,000 Less cost of Sales 650,000 Gross Trading Profit1,690,000 Less running Expenses1,100,000 Net Profit 590,000 Less int. on T’s capital @ 10% 50,000 Less ASF for contents 40,000 Net Operating Profit 500,000 Analysis of accounts:

Dual Capitalisation: Take rent at 50%£ 250,000 x YP perp @ 10% 10 £2,500,000 Capitalised Earnings: Net Operating Profit:£ 500,000 x YP perp @ 20% 5 Market Value of Hotel£2,500,000 or Valuation: Revpar = revenue per room Occupancy rate… Application of method – simple example

More detail... Net Sales (weekly ave = 52,740) 2,750,000 Gross Profit2,200,000 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 Total1,930,000 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)

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