Profits Method/Account Method

1.1 INTRODUCTION

• The Profits Method is also known as Accounts Method or Receipts and Expenses
Method. This method is normally used in the valuation of special properties such as
hotels, petrol stations, theme parks, golf courses, and cinemas. It is commonly used
where there is an absence of sales and rental evidence whereby the Comparison
Method and Investment Method are not applicable.

1.2 CONCEPT

• The value of a property is not determined by the characteristics of the property but by
the business activities carried out on the property
• The profits obtained from the business activities is an indication of the rent that
aninvestor is willing to pay for the property
• The higher the profits is, the higher is rental. Rent is an indication of capital value.

1.3 WHEN IS IT USED?

The Profits Method is used to value the following types of properties:
• Properties that are profit-motivated i.e.: properties with business activities carried out on
its premises such as entertainment centers, restaurants, cinemas, racecourses, golf
courses, hotels, petrol stations, etc.
• There is a lack of market comparable;
• There is an element of monopoly. Monopoly means control over the whole or part of the
market and its customers due to lack of, or very little competition within that business.
Monopoly is divided into two types:

a) Factual/ Physical Monopoly

For example, a hotel in Tioman Island, being isolated and only a limited number of hotels
on the island, enjoys some form of monopoly.
b) Legal Monopoly
A legal monopoly is enjoyed by a business through benefits it enjoys through legal
provisions. For example, the Local Authority of a town only allowed one cinema to operate
in that township. Because no other cinema is allowed to operate, there is no competition;
hence, the only cinema will enjoy good profits.

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1.4 MATTERS TO BE CONSIDERED IN THE PROFITS METHOD

• The Profits Method equation comprises a number of components. From the items given,
it isimportant to identify which item falls into which category of components.
• The components shown in the Profits Method equation are basically the main features of
the method. They illustrate what is involved in the valuation using this method.
• Trading performance to be from accounts over a minimum of 3 years.
• The Valuation Equation:

Gross Revenue

Less Purchasing Costs/ C o s t o f g o o d s s o l d

Plus Other incomes

Gross Profit p.a

Less Operational Costs/Working Expenses
Equal to Divisible Balance/Net Profit

Less 1) Interest on Capital (invested amount)

2) Operator’s share (risk and profit)
Equal to Gross Rent (Annual Value)
Less Outgoings

Equal to Net Rental

X YP to Perpetuity @ i%
OR X YP Dual Rate@i%, ASF@X%, Tax@Y%
Equal to Market Value

1.4.1 Gross Income/Earnings per annum

Gross earnings include all earnings from the business such as sales and services but exclude
any rental income from the subject property that is being valued. For example, the gross earnings
for petrol stations do not only come from sales of fuel but include earnings from car washes, coffee
kiosks, and convenience stores.
Rental income from the property such as rentals from teller machines, fast food outlets, etc. is
not considered part of the business and must not be added as part of the income business.In the
case of a shopping mall, rentals of shopping arcades are not part of the hotel operation and
therefore will be added as rental income of the hotel business.

Information from the account over a minimum period of 3 years, to establish a trend
Why 3 years?

• To ascertain whether the profits have increased or decreased

• To ascertain whether the business has the potential for expansion
• To ascertain items to be considered in the calculation of annual purchasing costs and
operational costs

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1.4.2 Purchasing Costs

• Raw materials or stock bought such as kitchen utensils for a restaurant, and film
rental foracinema are examples of purchases of the business.
• The cost must be deducted from gross earnings to obtain the gross profit.

1.4.3 Gross Profit

• The Profit are still considered “gross” because it includes operational costs and outgoings

1.4.4 Operational Cost/ Working

• Cost required for the operation/ running of the business

• Include wages, SOCSO, transportation, licenses, permit, utilities, stationery,
advertisement, and management expenses.
• The cost varies from year to year, therefore need to ascertain the average over 3 years
• Non-recurring items should be excluded, e.g., redundancy payments, capital
expenditure(purchasing of plant and machinery and vehicles)

1.4.5 Net Profit/Divisible Balance

• The net profit is obtained by deducting operating expenses from the gross earning. The
net profit is referred to as the divisible balance of the business.

1.4.6 Interest on Capital

▪ Capital means the capital required to start the business, not the capital to build the
premises.
▪ Capital refers to the amount which the tenant has invested in the business such as
capital tiedup in fixtures, fittings, chattels, stock-in-trade, and cash in hand.

▪ Examples of capital required for the business are a projector for the cinema,
utensils,cooking utensils for restaurants

▪ In other words, interest on capital is an opportunity cost to the operator.

▪ The general level of the current interest rates in the market will determine the rate of
interest to be applied in the valuation.

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1.4.7 Entrepreneurs/Operators/Tenant Share
▪ There are the remuneration and risk of the entrepreneur or tenant operating the
business
▪ The success of a business requires not only capital but also a competent entrepreneur who
is knowledgeable energetic and skilled in conducting the business. There must be
compensation.
3 normal ways of calculating entrepreneur/tenant share:
▪ Taking a percentage of the annual turnover
▪ Taking the percentage of total capital invested
▪ Taking the percentage of the divisible balance (40%-60%)

In a case where the owner of the building runs the business himself, he is considered a
hypothetical operator. Therefore, he is entitled to the tenant’s share as well.

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1.4.8 Gross Rent

• This is the indication of the ability to pay the annual rent of the property. This may not be
actual, but the amount that should be put aside/paid as rent
• The rent is gross; meaning the owner of the property has to pay all expenses of outgoings

1.4.9 Outgoings

• Outgoings are expenditures incurred for the upkeep of the property such as repairs
(external & internal), the premium for insurance, quit rent, assessment, and
management.
• Actual information from previous records may be used to determine the number of
outgoings of the property. However, estimates of outgoing can be obtained by taking a
percentage of the gross rental value for example 20%-30% of gross rental value.
• The gross rental minus outgoings will give the net rental value of the property.
Multiplying the net rental value by an appropriate year’s purchase will arrive at the
market value ofthe property.

1.5.1 Net Rent

• The net rent can be capitalized by investment method

• Net rent x YP in perpetuity of term @ i%
• Where i is All Risk Yield, the yield or capitalization rate of similar property in the locality
• For leasehold property, the YP used is dual-rate to reflect the risks inherent in leasehold
properties

1.5.2 Advantage of Profits Method

• For a certain type of property, the earning capacity of the business carried out on the
property has an important bearing on its market value. Hence, valuing such property
using the Profits Method is more appropriate.
• Certain property has an element of factual or legal monopoly, thus other methods of
valuation might not be applicable or suitable.
• The market value is derived by using the audited accounts of the business carried out on
the property, thus it is more reflective of the actual situation of the property in the market.
• This method is suitable to determine the annual value of special properties

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1.5.3 Disadvantage of Profits Method
• The earning capacity of the business is also dependent on the entrepreneurial skills
anddedication of the operator, hence affecting the market value of the property.
• Past accounts may not reflect the future direction of the business.
• For a new property or new business, this method may not be appropriate due
to the unavailability of past accounts.
• Difficult to determine the rate of return in view of the lack of capital/rental evidence of
similar properties.
• The owner of the property has no control over the business operating on the premises
ifthe business is operated by another person. Therefore, the earnings of the business
may not reflect the actual potential of the property.
• Challenges – to get accurate and timely data

• Analysis of data – difficult

o 3 years account – average or increases trend?

o Accuracy of data – suspicious, which account?

o Potentiality of business – adjustment of average

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