Income Approach: Profit Method Valuation

Income Approach: Profit Method

Principles and Basis

  • Also known as profit method.
  • Value of property depends on profits generated by business activities on the premises.
  • Suitable for valuing profit-generating properties.

How it Differs from Other Valuation Methods

  • Used to determine the rental value of a property.
  • Rental value indicates capital value.
  • Rental value indirectly estimates capital value.
  • Rental value is derived from the business profit at the property.
  • The value of a property is determined by the profitability of the business.
    • The building characteristic is not the main determinant.

Profit and Rent Relationship

  • Profit from business shows the amount of rental a tenant is willing to pay.
  • Higher profit leads to higher rental and higher capital value.

Use Cases

  • Used to value business properties with monopoly elements.
  • Examples: Hostels, petrol stations, entertainment centers (cinema), restaurants.

Monopoly Elements

  • Property has controlling power over the market due to:
    • Lack of competition.
    • Expertise within the business.
Types of Monopoly:
  • Factual Monopoly:
    • Enjoyed through goodwill.
    • Business is well-known for products or has operated in the market for a long time.
  • Legal Monopoly:
    • Enjoyed through legal provisions.
    • Example: Local authority only allows one cinema in a township.

Profit Method Formula Components

1. Estimated Gross Income (Per Annum):
  • Total income of a business (yearly basis).
  • Derived from sales and services.
    • Examples:
      • Sales of petrol.
      • Sales of tickets for cinema.
      • Room charges.
2. Purchasing Cost:
  • Cost of the main goods or services sold.
    • Example: Cost to purchase petrol stock for petrol stations.
3. Gross Profit:
  • Gross Profit=Gross Income−Purchasing CostGross\ Profit = Gross\ Income - Purchasing\ Cost
4. Operational Cost/Working Expenses (Per Annum):
  • Costs required for day-to-day operation of a business.
  • Includes:
    • Staff salaries.
    • Transportation.
    • Permits.
    • Licenses.
    • Utilities.
    • Stationery.
    • Advertisements.
5. Net Profit (Divisible Balance):
  • Net Profit=Gross Profit−Operational CostNet\ Profit = Gross\ Profit - Operational\ Cost
6. Interest on Capitals:
  • Interest payable by the entrepreneur on money borrowed for capital to operate the business.
  • Capital can include:
    • Furniture.
    • Equipment.
    • Stock.
    • Cash.
  • Excludes capital to build the premises.
  • Cost of borrowing and opportunity cost.
7. Entrepreneur's Share/Operator's Share:
  • Remuneration for the business operator's entrepreneurship and risk-taking.
  • Requires a competent, knowledgeable, energetic, and skilled entrepreneur.
  • The percentage sometimes is given and well known, but may require calculation.
8. Gross Rent
  • Gross Rent=Net Profit−Interest on Capitals−Entrepreneur′s ShareGross\ Rent = Net\ Profit - Interest\ on\ Capitals - Entrepreneur's\ Share
9. Outgoings:
  • Expenses related to the property.
  • To maintain property in good condition to support business operations.
  • Includes:
    • Management costs.
    • Insurance.
    • Quit rent.
10. Net Rental (Per Annum):
  • Net Rental=Gross Rent−OutgoingsNet\ Rental = Gross\ Rent - Outgoings
11. Capital Value/Market Value:
  • Capital Value=Net Rental×YP to PerpetuityCapital\ Value = Net\ Rental \times YP\ to\ Perpetuity
  • YP to perpetuity =1i= \frac{1}{i}, where ii is the yield of the property.
  • ii (Yield Percentage): Typically 8%−9%8\% - 9\% for commercial properties.
    • Locations affect the rate of return
  • YP (Year's Purchase):
    • Use Dual rate for leasehold property.
    • Use YP in perpetuity for freehold property.

Required Records

  • Accounting records needed.
  • Income statements: historical record of trading of a business, profit, or loss.
  • Balance sheets: Total assets and liabilities of the business at the end of the accounting period.

How to Use Records

  • Identify which items fall into which component of the profit method equation.
  • Use records pertaining to three years accounting period to ascertain an average.

Challenges of Using Profit Method

  • Difficulty obtaining accurate and timely data (private and confidential data).
  • Operators may avoid or refuse to cooperate.
  • Difficult to analyze the data, get the average of three years accounts, look at the trend.
  • Difficult to verify the accuracy of data/ suspicious account issues.
  • Assessing the potentiality of the business.
  • Difficult to identify a fair and appropriate share for the entrepreneur.
  • The profit method is the last approach to be used if other methods are appropriate because:
    • Other methods are easier.
    • Comparison method is commonly used for petrol stations because it is easier to find almost similar petrol stations nearby.

Example Calculation

Given:
  • Freehold petrol station.
  • Annual expenditure (average of three years):
    • Includes salaries, purchasing of stock, cleaning and gardening, administration, water and electricity, telephone bills, quit rent, assessment, repairs and maintenance, insurance, operators share.
  • Gross sales.
  • Other income(rounding 95 & 97).
  • Capital expenditure.
  • Rate of return capitalization at 9%9\%.
Steps:
  1. Calculate Gross Income:
    • Gross Income=Sales+Other IncomeGross\ Income = Sales + Other\ Income
  2. Calculate Gross Profit:
    • Gross Profit=Gross Income−Purchasing CostGross\ Profit = Gross\ Income - Purchasing\ Cost
  3. Calculate Net Profit:
    • Net Profit=Gross Profit−Working ExpensesNet\ Profit = Gross\ Profit - Working\ Expenses
  4. Calculate Gross Rent:
    • Gross Rent=Net Profit−Interest on Capitals−Entrepreneur′s ShareGross\ Rent = Net\ Profit - Interest\ on\ Capitals - Entrepreneur's\ Share
  5. Calculate Net Rent:
    • Net Rent=Gross Rent−OutgoingsNet\ Rent = Gross\ Rent - Outgoings
  6. Calculate Capital Value:
    • Capital Value =Net Rental×YP Perpetuity at 9%= Net\ Rental \times YP\ Perpetuity\ at\ 9\%.
Steps Breakdown with formulas:
  • Gross Income Calculation:
    • Petrol Sales: 120,000×12×Price120,000 \times 12 \times Price (Price is sale price per unit)
    • Other Sales: 95,000×12×Price<em>other95,000 \times 12 \times Price<em>{other}, 97,000×12×Price</em>other297,000 \times 12 \times Price</em>{other2}
    • Add other incomes to get total gross income.
  • Subtract Purchasing Cost:
    • Given as "purchasing of stock".
  • Subtract Working Expenses:
    • Salaries, cleaning, gardening, administrations, water & electricity and Telephone expenses.
  • Calculate Net Profit (Divisible Balance):
    • Gross profit - working expenses.
  • Subtract Interest on Capitals and Entrepreneur Share:
    • 10%10\% from the purchase of future, assumed purchase furniture 500,000500,000 for interest on capital.
    • Entrepreneur share is 40%40\%.
    • Normally Calculate it From The Divisible Balance Or Net Profit.
  • Calculate Gross Rent:
    • Net profit - (interest on capital + entrepreneur share).
  • Calculate Net Rent:
    • Subtract outgoings.
      • quit rent, assessment, repairs, and insurance.
  • Calculate Capital Value/Market Value:
    • Net rental times YP perpetuity at 9%9\%. Formula: 10.09=11.1111\frac{1}{0.09} = 11.1111

Conclusion

  • Profit method is not difficult.
  • Data accuracy crucial for proper valuation.
  • Data from financial accounts needs to be checked in detail.
  • The basic principles are straightforward. Data can be challenging to acquire and analyze. and also to identify the items. (Refer to notes above)