Profits method of

valuation

© University College of Estate Management 20114 P10507

Contents
1 Learning outcomes...............................................................................1
2 The profits or accounts method..........................................................1
2.1 Method of valuation..........................................................................................
2.2 Use of the profits method.................................................................................
3 Summary................................................................................................4
4 Appendix................................................................................................5
4.1 Cavenor Club valuation for rent of the freehold interest in the premises........
5 Terms and conditions of use...............................................................7
1 Learning outcomes
After studying this paper you should be able to:
 Identify the situations where the profits method is applied.
 Carry out profitability calculations for typical developments using
known values and costs.

2 The profits or accounts method

The profits method is based on the premise that certain specialists are not
capable of valuation according to comparative principles owing to their unique
location and characteristics. Where such properties are identified as revenue
earning, an annual value (a rental value) can be ascribed to them according to
earning capacity.
Thus, the method is normally used to estimate rental value in the case of
certain properties where:
 some element of monopoly exists (this may be a legal or factual
monopoly); and/or
 no direct comparisons of rents are available.
Consider, as an example, a cinema with four screens located in a town centre.
Whilst there may be comparable evidence of other town centre cinemas sold in
the market place, the building characteristics, location and, most importantly,
the trading potential is unlikely to be similar. Thus the valuer works on the
premise that it is sales per annum that will be the major determinant of an offer
for rent. Any purchaser in the market (with a few exceptions) can only bid for
rent that the business can afford and this must ultimately depend on profit.
The following properties are normally valued by the profits or accounts method:
 hotels
 public houses
 cinemas and theatres
 petrol stations.
The profits approach is used for those properties where competition is
restricted. It is based on the principle that the rental value will usually be
proportional to the volume of trade carried on.
Earning capacity will depend on gross earnings which, in turn, will depend on
the volume of trade.

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2.1 Method of valuation
The first step in the profits method is to obtain at least the three previous years’
accounts for the business. From this, it is possible to estimate the net profit
from the annual gross earning, as follows:

Estimated gross earnings £

Less Purchases £
Gross profit £

Less Working expenses £

Divisible balance (net £
profit)

This apparently simple exercise will, in practice, be found to be rather more

complex. The accounts will have to be examined critically, to judge:
1. Whether they represent the performance of a reasonably capable trader
and are neither too high to sustain nor too low to reflect the trading
possibilities.
2. Whether adequate allowances have been made for the various
expenses, or whether these are artificially low to give a better looking
business.
3. Whether any unusual items or conditions have affected the accounts for
the year under consideration, e.g. a major repair programme or other
investment.
4. Whether the expenses are all properly allowable in an assessment of
notional rental value (see below).

2.1.1 Trading performance

The figure of gross earnings will be the basic information. This should first be
looked at over a minimum period of three years, to see the trend and to
estimate an average expected turnover. The valuer’s experience of the type of
operation will enable him to judge the validity of the figures, and whether more
effective business methods and marketing could improve the turnover. If the
business is being sold, the operator will be anxious to show good results, but
actual accounts may be unreliable if the trader has sought to falsify receipts for
tax evasion. Knowledge of similar businesses might therefore be preferred to
actual accounts.

2.1.2 Purchases
This item would include the cost of commodities to be sold (e.g. food and drink
in the case of a hotel).

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2.1.3 Working expenses
These again would be considered over a period of several years.
 Non-recurring items, e.g., redundancy payments, should be
excluded because they will not be expected to recur in a typical year.
 It is also important to include only revenue expenditure and not
capital sums. The purchase of plant, machinery and vehicles, for
example, is capital expenditure. This is not a cost in the year it is
bought but is to be spread over its useful life.
 An annual allowance for depreciation should be made on capital
equipment to allow for its wearing out.
Certain other types of expense need careful consideration, wages (the cost of
any casual staff), repairs and insurance (a proper annual allowance must be
included irrespective of the state of repair), etc.

2.1.4 Tenant’s share

The final stage will be to make a further deduction from the net profit. This is
known as the ‘tenant’s share’, to represent interest on the capital which the
tenant has invested in the business and a remuneration to the tenant for his
risk and enterprise. (The term ‘tenant’ in this context may be the owner-
occupier.) Tenant’s share is usually about 50% of net profit.

Divisible £
balance
Les Tenant’s share:
s
Interest on capital at say 7% £
Remuneration to the ‘tenant’ £
Balance £

This balance will be available for the payment of rent.

2.2 Use of the profits method

Where suitable comparable evidence is not available, the profits method is
often used in rating assessments.
The profits method can also be used to calculate the capital value of such a
property. In capital value calculations, the valuation of the land
The profits or accounts method
and buildings is bound up with the business profits and it is difficult to separate
the elements. Normal valuation practice therefore is to analyse the relationship
between net profit and sale value of the property as an operational entity, to
derive a YP for comparison purposes. The capitalisation rate/YP will therefore

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 be on a figure which includes both rental value and operator’s return (e.g. 4—5
YP, giving a 25—20% return on that investment).
The actual accounts may not always be a true indication of the earning capacity
or value of the property. Therefore this method must be used with caution and
should be checked by any comparable evidence available. For example, for
licensed premises (public houses) the rent is often checked by a unit of
comparison based on the estimated barrelage, i.e. x pence per barrel. In the
case of a cinema the rent could be checked by using a unit of comparison
based on the value per seat.
Example 3

Gross earnings £249,000

Less Purchases £120,000
Gross profit £129,000
Less Working expenses £70,000
Divisible balance £59,000
Less Interest on capital £46,000 at £3,220
7%
Sum available for payment of rent and tenant’s
remuneration to be agreed on approximately 50:50 basis. £55,780

A more detailed example of a profits method valuation is shown in the

Appendix at the end of this paper.

3 Summary
The profits or accounts method:
 Is used to find rental value of properties where
o there is some element of monopoly and/or
o annual value is dependent upon turnover and there is no
general market for the kind of property in question.
 Is commonly applied to valuations of hotels, public houses, petrol
stations, cinemas, though often in a shortened form, e.g., petrol
stations where rental value is based on £x per 1,000 gallons per
annum sales.
 Consists in deriving net profit excluding rent and tenant’s reward,
and apportioning the resultant amount between interest on the
tenant’s capital, rent, and tenant’s remuneration. 

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4 Appendix
4.1 Cavenor Club valuation for rent of the freehold
interest in the premises
The club’s landlord has instructed you to value the property for rental purposes
and has supplied the last three years’ income and expenditure accounts. The
premises comprise a converted mill with restaurant, bars and sports facilities. It
is situated on a site on the fringe of a large town.

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Adjusted accounts from previous three years

Bar 90,000
Restaurant 120,000
Outside catering 12,000
Members’ subscriptions 4,500
Rooms 6,500
Other 3,875
Total 236,875
Purchases @ 50% food and drink sales (comparing previous 105,000
years)
Estimated gross profit 131,875
Expenditure
Wages & NI 34,600
Office expenses 17,000
Drawings — no allowance\part of profit
Loan interest — no allowance
Bank charges 1,475
Accountants 1,470
Telephone 645
Electricity 8,743
Business rates 8,094
Environmental charge, say 1,500
Repairs: reasonable average 2,400
Vehicle servicing 750
Petrol 1,200
Insurance 1,800
Contents 1,000
Other 200
Bad debts 450
Laundry 568
Advertising 1,765
New furniture — no allowance:
Depreciation on furniture and equipment @ 10% of total value, say 5,000
Total expenses 88,660
Expected future net profit 43,125
Divisible balance 43,125
Interest on operator’s capital @ 8% (stock, cash float, furniture, 4,800
etc.) say
38,325
Half to rent 19,000

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5 Terms and conditions of use
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