PROFIT METHOD

Sr IDZWAN IZUDDIN SHAH HAJI ISHAK

Registered Valuer V1088
 INTRODUCTION
◻ Also known as Accounts Method.
◻ Rest on the thesis that the value of a property is
related to the profits generated by the business
activities carried out on its premises.
◻ It is different from the other methods of valuation
because it is used to determine the rental value of
property.
◻ However, because rental value is an indication of
capital value, the Profits Method can also be used
to indirectly value a property.
 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 profit obtained from the business activities is
an indication of the rent that an investor is willing
to pay for the property.
◻ The higher the profit is, the higher is the rental.
Rent is an indication of capital value. Therefore,
the higher the rent is, the higher is the value.
◻ Therefore, value = fx (profits)
 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 station, etc.
⬜ Properties with 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 (2) types:
 WHEN IS IT USED? (con’t)
a) Factual Monolopy
◻ Factual/Business monopoly is enjoyed by a
business enterprise through goodwill i.e.:
when the business enterprise is well known for
the services that it offers, or when it has been
operating in the market for a long time
(branding).
◻ Eg: Hilton hotel, Coca-cola etc
 WHEN IS IT USED? (con’t)
b) Legal Monopoly
◻ 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.
MATTERS TO BE CONSIDERED IN
THE PROFITS METHOD
◻ The Profits Method equation comprises a number
of components. From items given, it is important to
identify which item falls into which category of
component.
◻ The components shown in the Profits Method
equation are basically the main features of the
method. They illustrate what are involved in the
valuation using this method.
◻ Trading performance to be from accounts over a
minimum of 3 years
 FORMULA
Estimated Gross Income/Earnings p.a
LESS Purchasing Costs p.a
EQUALS Gross Profits p.a
LESS Operational Costs/Working Expenses p.a
EQUALS Net Profits/Divisible Balance p.a
LESS 1.Interest on Capital &
2. Entrepreneur’s Share
EQUALS Gross Rent p.a
LESS Outgoings p.a
EQUALS Net Rent p.a
(X) YP to Perpetuity @ i %
EQUALS Capital Value of the Property
FORMULA
 Estimated Gross
Income/earnings Per annum
◻ Information from account over a minimum period of 3 years,
to establish a trend.
◻ Why 3 years?
⬜ to ascertain whether the profits has 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.
◻ Accounts are normally from income accounts, profit and loss
accounts or balance sheet.
 Purchasing Costs
◻ These are costs of acquiring the trading items
example petrol for petrol station, film rentals for
cinema, ingredients for food served by a restaurant.
◻ Exclude capital expenditure such as purchasing pots
and pans, tables, chairs etc.

Gross Profit
◻ The profits are still considered “gross” because it
includes operational costs and outgoings
 Operational Cost/Working
Expenses per annum
◻ Cost required for the operation of a business
◻ Include wages, SOCSO, transportation, licences,
permit, utilities, stationery, and advertisement.
◻ The cost varies from year to year, therefore need to
ascertain average over 3 years.
◻ Non-recurring items should be excluded, e.g.
redundancy payments, capital expenditure
(purchasing of plant, machinery and vehicles)
◻ Annual allowance for depreciation of the capital
equipment should be included in the operational cost.
 Divisible Balance/Net Profit
◻ Reflects the amount available for rent
◻ Need to take into account two items:
i) Interest on Capital
- Capital means the capital to start the business, not the
capital to build the premises.
- Example of capital required for the business are
projector for the cinema, utensils, cooking utensils for
restaurants.
- This capital usually financed by bank loans where
interest is charged at a certain percentage.
- The interest paid to the bank is a form of cost, thus it
should be deducted from profits
 Divisible Balance/Net Profit
(con’t)
ii) Entrepreneur’s /Operator’s/Tenant Share
- These are the remuneration and risk of the entrepreneur or
tenant operating the business.
- The success of business requires not only capital, but also a
competent entrepreneur who is knowledgeable, energetic and
skilled in conducting the business. These must be compensated.
- 3 normal ways of calculating entrepreneur/tenant share:
i) Taking percentage of the annual turnover
ii) Taking percentage of total capital invested
◻ iii) Taking percentage of the divisible balance (40%-60%)
 Gross Rent

◻ This is the indication of the ability to pay

the annual rent of the property. This may
not be the actual rent, 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.
 Outgoings
◻ Outgoings are expenditures incurred for the upkeep
of the property such as repairs (external &
internal), premium for insurance, quit rent,
assessment and management
◻ These should be deducted from gross rent to derive
at the net rental.
 Net Rent
◻ The net rent can be capitalized by investment
method:
◻ Net Rent x YP in perpetuity/or term @i % =
Capital Value of the property.
◻ 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.
 EXAMPLE OF VALUATION
USING PROFITS METHOD.
➢Cinema
➢Petrol Station
➢Hotel
➢Restaurant
 Example of profits method
19

RM
Income 200,000
Less: Purchases ( 90,000)
Gross Profit 110,000
Less: Operating Expenses ( 38,000)
Net Profit 72,000

Con’t ->
 Calculation Example
(Small restaurant)
20

Net Profit 72,000

Less: Interest on Tenant’s Capital
Fixtures 16,000
Stock 8,000
Cash 4,000
28,000 @ 12% (3,360)
Adjusted Net Profit / Divisible Balance 68,640

Con’t ->
 Calculation Example
(Small restaurant)
21

Divided between rent and tenant’s share / proprietor’s remuneration

Say, 60% proprietors remuneration and 40% rent

Proprietor’s remuneration : RM68,640 @ 60%
= RM41,184

Rent (gross) : RM68,640 @ 40%

= RM27,456

Con’t ->
22

RM
Gross rental pa. 27,456
Less outgoings 5,000
Net rental pa 22,456
YP in perp @10% (1/i) 10
Capital value 224,560

Market Value 225,000

 TUTORIAL

PETROL STATION
2016

2019