Trade-related valuations and thetreatment of goodwillNeil A. Dunse and Norman E. Hutchison

Centre for Property Research, University of Aberdeen, Aberdeen,Scotland, UK, and

Alan GoodacreDepartment of Accounting, Finance and Law, University of Stirling, Stirling,

UK

Keywords Assets valuation, Goodwill accounting, Real estate, Market value

Abstract Guidance Note 1 of the Red Book states that the valuation of an operational entityincludes four components: the land and buildings; the trade fixtures and fittings; the tradingpotential, excluding personal goodwill; and the benefit of any transferable licenses and consents.Accounting changes in recent years have increasingly recognised the importance of intangibleassets such as intellectual capital and goodwill. Similarly, recent tax changes demonstrate thegovernment’s acceptance of the importance of such items in achieving and maintaining businesscompetitiveness. This paper has two key objectives: first, to analyse the application of the Red Bookto trade-related valuations, paying particular attention to the treatment of goodwill and second, tocritically evaluate the accounting treatment of goodwill and in particular the application ofFinancial Reporting Standard 10. In order to understand the workings of the market, thecorporate hotel sector was used as a case study. The key findings of the research are that valuersexpressed considerable unease with the apportioning of market value between tangible assets andgoodwill, there was no consensus on how (or if) goodwill could be measured reliably. Second, thatthe valuation methods adopted are, to a degree, naı̈ve. While explicit changes are made to thecash-flow projections, there is insufficient appreciation of the changing risk profile that might leadto an adjustment to the earnings multiplier. The accounting difficulties and inconsistenciesconcerning goodwill arise largely because of inadequate valuation methods. Recent tax changesalso point to the need for a robust and defendable valuation methodology. Application of one suchtheoretically sound approach to valuing goodwill (the bridge model) is illustrated in this paper.While the research focused on the corporate hotel sector, the findings have wider implications forother sectors of the market where operational entities are valued with regard to their tradingpotential.

1. IntroductionHistorically in the UK, the profits or accounts method has been the most commonmethod for the capital valuation of properties that are normally sold as fullyoperational business units (Marshall and Williamson, 1996). However, in recent yearsthe discounted cash flow technique (DCF) has been supported by a number oforganisations, most notably by the British Association of Hospitality Accountants(1993) and the US literature would suggest that it is the most common method adoptedin North America (Rushmore and Baum, 2001).

The Emerald Research Register for this journal is available at The current issue and full text archive of this journal is available at

www.em eraldinsight.com/res earchregister www.em eraldinsight .com/1463-578X .htm

The authors would like to thank the Education Trust for their financial support of this researchproject, to all the practitioners who gave up their time to assist with the research and to DavidStopforth (University of Stirling) for useful discussions on taxation.

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Received June 2003Accepted January 2004

Journal of Property Investment &FinanceVol. 22 No. 3, 2004pp. 236-258q Emerald Group Publishing Limited1463-578XDOI 10.1108/14635780410538168

Guidance Note 1 of the RICS Appraisal and Valuation Standards or “Red Book”(Royal Institution of Chartered Surveyors, 2003) does not concern itself withmethodology. The Guidance Note states that the valuation of the operational entityincludes four components: the legal interest in the land and buildings; the tradefixtures, fittings, furniture and equipment; the trading potential, excluding personalgoodwill, together with an assumed ability to renew existing licenses, consents,certificates and permits; and finally the benefit of any transferable licenses, consents,certificates and permits.

While the Red Book identifies the four components of value, the market value figurereported to the client is an overall sum, which is not disaggregated. However, valuesmay need to be apportioned for a number of reasons, most notably for tax, funding andbalance sheet purposes. The earlier version of the Red Book (Royal Institution ofChartered Surveyors, 1997) warned in Practice Statement 2.7 that such apportionmentis a hypothetical exercise and “the valuer must emphasize to the client and in hisreport, that the resultant figures are informal apportionments and that the individualfigures do not themselves represent the open market value of the elements involved,since the true valuation can only be the figure taken as a whole” (p. 8). In Appendix 1 toUK Practice Statement 1 of the Red Book (Royal Institution of Chartered Surveyors,2003), valuers are reminded that Financial Reporting Standard (FRS) 15 “suggests thatit would not be appropriate to treat trading potential associated with the property as aseparate component of the value of the asset, if its value and life were inherentlyinseparable from that of the property” (Royal Institution of Chartered Surveyors, 2003,p. UKA1.19).

Nevertheless, the disaggregated components of value may be used by the client andthird parties for a number of purposes: for example to assess a tax liability such asstamp duty, to calculate the level of debt capacity and to assess the financial strengthof the company through the analysis of the fixed assets in the balance sheet. Thus,while the disaggregation of the valuation may be hypothetical, the result may have realfinancial consequences for the client.

The valuation of trading potential and goodwill is an under-researched area and thispaper has two key aims. First, it analyses the application of Guidance Note 1 of the RedBook in the valuation of operational entities, paying particular attention to thevaluation of goodwill. The research focuses on the valuation of corporate hotels toillustrate the issues. Secondly, it critically evaluates the accounting treatment ofgoodwill and in particular the application of Financial Reporting Standard 10.

This paper is structured as follows. Section 2 considers the various aspects ofgoodwill, while Section 3 considers the tax and accounting treatment of goodwill.Section 4 provides a review of the literature on the valuation of trading properties andconsiders the various valuation alternatives. Section 5 reports on structured interviewswith market participants and Section 6 illustrates the various valuation methodologiesthrough a case study. Section 7 provides some conclusions and recommendationsarising from the research.

2. Trading potential and goodwillAt the outset of this paper it is necessary to make clear the meaning of, and differencesbetween, trading potential and goodwill. Lord MacNaghten in the House of Lords

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delivered the leading judgment on the meaning of the term “goodwill” on 20 May1901[1]:

It is a thing very easy to describe, very difficult to define. It is the benefit and advantage of thegood name, reputation and connection of a business. It is the attractive force which brings incustom. It is the one thing which distinguishes an old-established business from a newbusiness at its first start.

While this is a very useful starting point, it is necessary to consider the many formsthat goodwill can take. It is clear from this definition that for goodwill to exist there isneed for “custom” and “business” and it is from the viewpoint of the customer that thecourts have been able to assist in the further classification of goodwill. In WhitemanSmith Motor Co. Ltd v. Chaplin ([1934] 2KB 35) the courts defined four types ofcustomers (the aptly named “zoological classification”):

(1) The cat – who stays faithful to the location not the person.

(2) The dog – who stays faithful to the person and not the location.

(3) The rat – who is casual and is attracted to neither person nor location.

(4) The rabbit – who comes because it is close by and for no other reason.

Guidance Note 1 clearly states that the valuer must exclude personal goodwill (GN1.4.1). This is logical as the skill, personality and other personal attributes of theproprietor are personal to him or her and are not expected to remain with the businessin the event of the subject property being sold. Using the above analogy, the behaviourof the dog must not be considered.

In preparing a trade related valuation, the valuer is looking to estimate “the marketvalue as a fully-equipped operational entity, regarding to trading potential” (GN1.3.3),which in animal parlance, is derived from the behaviour of the cat and the rabbit and istopped up by the rat! This puts emphasis on the attractiveness to potential customersof the location, design and licence for a particular established use, given that the valueris to assume an “average competent operator” (GN1.4.2). Significantly, the valuecalculated attaches to the building and runs with the property, irrespective of a changein ownership. This definition was formerly known as “inherent goodwill” (GN1.4.3) butis now referred to in the Red Book as the trading potential. Under these circumstancesa business, which is well established, is likely to have a higher value than the one thathas recently been constructed. In the latter case, the trading potential – the potentialconsumer spend of the cat, rat and rabbit – has not been established with any degree ofcertainty and the valuer, in attempting to determine the most likely category of buyerfor the new business, has to make subjective judgments on the initial level of trade.

The Shorter Oxford Dictionary provides us with another definition and aspect ofgoodwill:

The privilege granted by the seller of a business to a purchaser of trading as his recognisedsuccessor; the possession of ready-formed connection with customers considered as aseparate element in the saleable value of a business.

The key part of the definition is that here goodwill must be a “separate element in thesaleable value of the business”. This is then emphasised in GN1.4.1, which states thatthe goodwill must be able to be passed to the purchaser of a property.

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This “separate saleable goodwill” may, for example, attach to product lines andbrand names. Importantly, this type of goodwill is capable of being transferredindependently of the property from which the business is currently being conducted,albeit that increasing distance from the original location may significantly reduce thevalue of the goodwill. Brand awareness is considered vital in selling retail products andbrand names are regularly sold as separate saleable items. The valuation of brandnames is not part of this research paper which focuses on trading properties.

3. The tax and accounting treatment of goodwill3.1 TaxThe sale of a hotel business typically involves the sale of a group of assets such asgoodwill, plant and machinery, as well as the trade premises. Different assets mayattract different tax treatments, so it is important to be able to identify the variouselements separately. Some assets will qualify for capital allowances at different ratesand some will not qualify for capital allowances at all. It is essential that the priceapportionment is realistic (or it may be challenged by the Inland Revenue) and isagreed with the other party to the transaction at the time of the transaction to avoidlater complications. Often, favourable tax treatment for the purchaser may lead tounfavourable treatment for the seller.

The apportionment may also have an impact on the calculation of the capital gainfollowing a future sale of the business. The amount of stamp duty payable on atransaction may also be affected by the apportionment of value between the variousassets; the sharply increasing rates of stamp duty over recent years have accentuatedthe importance of apportionment.

3.2 AccountingThe recognition of goodwill on a firm’s balance sheet will impact on variousperformance measures. Assets and shareholders’ equity will both increase so, ceterisparibus, profitability measures like return on assets and return on equity will decrease.A positive effect will be that financial risk (gearing) measures, such as debt-to-equity,will typically improve. This may help some firms to avoid breaches of loan covenantsand, depending on the attitude of lenders to the intangible goodwill asset, may increaseassets available to support the additional borrowings. The requirement to amortisegoodwill over its useful economic life reduces reported profit and the earnings pershare indicator. The particular circumstances of a firm will dictate whetherstakeholders perceive the overall impact to be positive or negative.

In the UK, Financial Reporting Standard 10: Goodwill and Intangible Assets (FRS10)defines intangible assets as “non-financial fixed assets that do not have physicalsubstance but are identifiable and are controlled by the entity through custody or legalrights” (ASB, 1997). Identifiable assets are further defined as those “that are capable ofbeing disposed of or settled separately, without disposing of a business of the entity”;thus identifiable really means “separable”. A wide range of assets comes within thescope of intangibles including patents, trademarks, brands, domain names, customerlists, computer software and goodwill.

The whole question of which intangible assets can be recognised in accountingterms has been, and continues to be, a difficult one for accounting standard setters. Thereal economic value of intangibles to businesses and their increasing importance is not

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at issue. Rather, the debate concerns whether the present accounting model canadequately capture and report useful information about intangibles.

The increasing importance of intangibles has been recognised by the UKgovernment, which is at present seeking to encourage investment in such assets bychanging tax rules. First, tax credits on R&D expenditure are being introduced,bringing the UK treatment closer to that already adopted in other countries such asGermany and the USA. The second change concerns the tax-deductibility ofexpenditure on assets. Currently, when computing taxable profit, companies areallowed to charge depreciation on certain tangible fixed assets as an expense byapplying special “capital allowances” rules defined by the Inland Revenue. A recentproposal has been put forward to allow similar treatment for intangible assets acquiredby companies (Inland Revenue, 2001). The proposed treatment is that newly-acquiredintangibles should be dealt with for tax purposes in accordance with normalaccounting practice (rather than application of special tax rules), thereby following anincreasing trend to align UK tax and accounting rules. Thus, the identification andvaluation of intangible assets is becoming increasingly important.

The accounting treatment of intangibles often varies depending on whether theyhave been purchased or internally generated. If a market exchange has taken place,then the issues of identifiability (separability) and valuation are more easily resolved;thus, purchased intangibles are more often recognised. For example, the relevantinternational accounting standard, IAS 38 (IASC, 1998), requires that an intangibleasset should be recognised if two criteria are met. First, if it is probable that the futureeconomic benefits that are attributable to the asset will flow to the enterprise and,second, if the cost of the asset can be measured reliably. By contrast, the lack of marketvaluation for internally generated intangibles increases the measurement uncertaintyand often leads to non-recognition.

Once an intangible asset has been recognised, a further major issue concerns how todeal with changes in the value of the asset. Should a decrease in asset value beexpected and the value be amortised (depreciated) over the asset’s useful life? Shouldthere be a maximum duration for useful life (five, 20, 40 years)? Alternatively (or evenadditionally?), should the asset be assessed annually for a decline in value (impairment)which should be charged against profit immediately? Possibly, some intangibles maynot be expected to suffer a decrease in value and/or may have infinite useful life,implying no amortisation or impairment charges. Different combinations of theseassumptions are applied in different countries, and have also been applied withinindividual countries at different times. Currently, there seems to be little agreement onthe most appropriate treatment for changes in the value of intangible assets (Stolowyand Jeny-Cazavan, 2001).

Indeed, there are significant differences between countries in the overall treatmentof intangibles both within Europe and beyond. The differences between nationalaccounting standards and the IAS 38 (IASC, 1998) are likely to create difficulties inEurope following the European Commission requirement that all listed EU companiesmust prepare accounts in accordance with international accounting standards from2005 onwards. Country differences are also likely to hamper the move towardsinternational harmonisation (Stolowy and Jeny-Cazavan, 2001).

However, one aspect on which there is universal agreement by accounting standardsetters is that internally generated goodwill should not be recognised on company

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balance sheets. The views of standard setters seem to reflect a greater concern forreliability rather than relevance of financial statements (Canibano et al., 2000). Theabsence of market-based values is likely to increase subjectivity and uncertainty in thevalues placed on internally generated goodwill and this is presumed to reduce theusefulness of the information[2]. The difference between the treatment of purchasedand internally generated goodwill has been criticised by accounting academics (e.g.Arnold et al., 1994; Egginton, 1990; Ma and Hopkins, 1988). They argue that it isimportant to treat both purchased and internally generated goodwill in a consistentmanner to avoid an “uneven playing field”. Otherwise, there is a “serious problem ofaccounting comparability between companies which acquire intangibles externallyand those which develop them internally” (Egginton, 1990).

For the UK, FRS10 sets out the principles of accounting for goodwill and intangibleassets. It requires that purchased goodwill should be capitalised and classified as anasset in the balance sheet, but that internally generated goodwill should not becapitalised. Purchased goodwill is defined as the difference between the cost of anacquired entity and the aggregate of the fair values of that entity’s identifiable assetsand liabilities.

FRS10 seeks to charge goodwill to the profit and loss account, through systematicamortisation, only to the extent that the carrying value of the goodwill is not supportedby the current value of the goodwill within the acquired business. The useful economiclife of purchased goodwill is defined as the period over which the value of an acquiredbusiness is expected to exceed the values of its identifiable assets and liabilities. Thereis a rebuttable presumption that the useful economic life of purchased goodwill islimited and does not exceed 20 years from the date of acquisition. Further, UKcompany law requires goodwill to be amortised and if the financial statements departfrom this requirement then an explanation is required.

From a valuer’s perspective, a key question emerges from FRS10. Why is internallygenerated goodwill not included in the balance sheet? The answer may well lie in theconservative nature of the accounting profession but, as the exclusion of goodwillunderstates the book value of going concern businesses, is this appropriate? If the valueris able to differentiate between the value of the tangible and intangible assets then thereis a place for recording the goodwill value in the accounts and thus fully reflectingshareholder value. To have one set of rules for purchased goodwill and another forinternally generated goodwill is potentially confusing. Moreover, what market evidenceis there that the useful economic life of purchased goodwill does not exceed 20 years?The rationale behind this is unclear and would benefit from further investigation.

4. Valuation of trading propertiesThe Red Book does not state the valuation method that should be used to undertake thevaluation of trading properties, however it would typically be a sales comparisonapproach or income capitalisation approach, specifically the earnings multiplier orcontemporary discounted cash flow. This section provides a brief outline of the lattertwo approaches.

4.1 Earnings multiplier approachUK valuation textbooks (Marshall and Williamson, 1996; Rees and Hayward, 2000)advocate the simple earnings multiplier approach (commonly referred to as the profits

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or accounts method) where the revenues and expenses of the business are analysed todetermine an adjusted net profit. The valuer, using his/her expertise, determineswhether this is a fair maintainable level of trade and assesses the expectation of itscontinuation in the future. This adjusted net profit figure is then capitalised at anappropriate yield, reflecting the relative risk of the business venture, to determine thecapital value of the business enterprise. The method is illustrated by a worked examplein Section 6.

4.2 Contemporary DCF methodCriticism has been levied by many in the surveying and related professions of theappropriateness of the traditional profit/accounts approach (Estates Gazette, 1994). Itappears from the US literature (Rabianski, 1996) that the DCF approach is commonlyused in that market. Still basing the assessment of value on analysis of revenues andexpenditures, the fair maintainable trade is projected over a longer time frame,typically five to ten years. This approach has been supported by a number oforganisations including the British Association of Hospitality Accountants (BAHA). Inaddition to considering future cash flows in more detail it arguably provides betteradvice to clients and lending institutions regarding future profitability. Again, Section6 illustrates the method with a worked example.

4.3 Capitalisation ratesAs with any other form of investment, the capitalisation of the adjusted net profitshould reflect the risk of the income flow. It is generally held that the income streamfrom a business is more risky than the income from a prime property investment. Theincome from a property investment, in the form of rent, is a contractual receipt,whereas profit from a business venture is a residual, i.e. what is left of the gross incomeafter deduction of all other outgoings. Consequently, the risk associated with thereceipt of profit depends on the relationships between income and fixed and variablecosts, as well as market conditions.

Another factor that must be considered when determining an appropriate yield isthe replacement of fixed assets (or depreciation). It is well accepted at present (Hoesliand MacGregor, 2000) that depreciation should be accounted for in all the risks yieldapplied in property valuation. In the case of a business containing assets other thanproperty, replacement of fixed assets is likely to occur over a relatively short timeperiod and in this instance the situation is analogous to leasehold valuations; i.e. theexplicit allowance of a sinking fund in a traditional leasehold valuation. Hence, theyield must reflect the fact that the investor should receive a return on capital and alsoensure that there is a return of capital over the life of the fixed assets.

Rushmore and Baum (2001) identify a number of further risks associated withbusiness ventures with particular regard to hotels. They argue that the discount ratecan be derived theoretically through risk and investment analysis. By beginning with arisk free rate the analyst should make a series of upward adjustments to reflect thedifferent elements of risk. Within a hotel example, the adjustments may be representedas general sector risk, management risk, food and beverage risk, rapid functionalobsolescence, lack of liquidity, and other elements such as design and locational risk. Inpractice, this is probably too subjective and instead, the valuer relies upon sales

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comparable evidence making implicit adjustments depending on the nature of thebusiness enterprise being valued.

Irrespective of whether the traditional profits method or a DCF approach is used, themethod only provides an indication of the open market value of the operationalbusiness. It does not split the value between the market value of the property withinwhich the business is conducted, and the market value of the intangible assets (i.e. thegoodwill). As explained earlier, it is often necessary to determine the market value ofthe elements separately, particularly for business funding and accounting purposes.

4.4 The bridge modelThe apportionment of value has been debated in the recent US literature (Lennhoff,1999). In response, Benson (1999) and Clark and Knight (2002) advocate the use of theso-called “Bridge model” which creates a bridge between the value of the going concernand the property’s constituent parts. The model is defined simply as:

GC ¼ Aþ Bþ BEV

where GC is the going-concern value, A is the value of land and buildings, B is thevalue of trade fixtures, fittings and equipment, BEV the business enterprise value.

The literature argues that the BEV represents the reward to the entrepreneur forassembling the components of the business and making the value of the whole greaterthan the sum of the individual values of the components. Knowing the open marketvalue of the operational business and the value of the tangible assets, the BEVrepresents a residual: “a value enhancement that results from items of intangiblepersonal property such as marketing and management skill, an assembled workforce,working capital, trade names, franchises, patents, trademarks, contracts, leases andoperating agreements” (Appraisal Institute, 1993, p. 44). It approximates to what theRICS Red Book currently refers to as the market’s perception of “trading potential”(formerly termed “inherent goodwill”).

However, the BEV cannot be established without knowing the value of the tangibleproperty and the operational business. As discussed earlier, this latter valuation can beestablished using standard procedures, although the correct approach is open fordebate. For a business using a standard commercial property unit (e.g. a newsagentoperating within a standard retail unit), the open market value assuming vacantpossession can be established using comparable evidence from recent transactions. Fora more specialised property, such as hotel, this method is not usually possible.

The US literature develops an approach for determining the property value forspecial properties like hotels. A DCF approach is adopted and estimates of the futurerevenues and expenses are calculated, as far as possible from comparable evidence onbusiness enterprises of similar size, type and scale. The assumption is made that theproperty is vacant and fully equipped for business, but not yet for trading. Therevenues and expenditures are estimated over a time period reflecting the gradualestablishment of the business. This is discounted at a rate of return that reflects theadded risk of this venture given that there is no established business. The differencebetween this figure (effectively the vacant possession value of a trading entity) and theopen market value of the operational business represents business enterprise value(BEV) or goodwill (Clark and Knight, 2002) (Figure 1).

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5. Structured interviews with market participants5.1 Sample selectionIn order to expand upon the conclusions drawn from the literature review and fullyunderstand the workings of the market, the authors undertook a qualitative analysis ofvaluer and lender practice in the corporate hotel sector.

Structured interviews were undertaken with a panel of ten valuation experts andwith representatives from three major clearing banks involved in lending to the hotelsector. The majority of the interviews were held on a face-to-face basis and took placeduring the summer of 2002 in London and Edinburgh. (See Appendix for a list of thecompanies interviewed.) The sample selection of valuers was chosen by followingrecommendations from experts in the field. This methodology ensured that the keyvaluers in this sector were represented in the sample, although the non-random natureof the selection process is acknowledged.

Information was also sought on current views concerning the accounting andtaxation issues facing the hotel sector. Interviews were held with a senior managerfrom one of the Big 4 chartered accounting firms with accounting knowledge andexpertise in the hotel sector and also with a senior tax consultant with specificexpertise in the hospitality and leisure sector.

The results from the structured interviews are considered under the four headingsof valuation methodology, apportionment, risk and accounting and taxation issues.

Figure 1.Comparison of new andestablished business

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5.2 Valuation methodology5.2.1 Valuers. All of the valuers confirmed that they used a range of methods to reachthe valuation figure reported to clients (Table I). For the majority of the valuers, theearnings multiplier approach was the primary method employed where the hotel waswell established and the trading figures were known. An explicit DCF approach wasalso used by nearly all the valuers to confirm the valuation figure along with the salescomparison method as a further cross check. Some of the valuers commented that thedominant method depended on the type of hotel being valued. For example, one valuerused the DCF approach where the hotel was a standard three star offering or apurpose-built budget hotel.

An explicit DCF approach was a more prominent method where a new developmentwas being valued or a major refurbishment planned. However, differences did emergein the selection of the holding period and the rationale used in selecting the discountrate. Eight of the valuers used a ten-year holding period with the other two believingthat a five-year holding period was the maximum realistic time horizon whenconsidering likely events in the hotel industry. In selecting the discount rate (equatedyield), a range of methods was used, from adding a risk premium to the grossredemption yield on long-dated gilts, to adding a risk premium (about 1 percent to 2percent) to the current market capitalisation rate for hotels of this type. The exactrationale for the level of risk premium was not clear. In all cases the exit yield wastaken to be the current market capitalisation rate.

However, some reluctance was expressed by a minority of the valuers as to thelegitimacy of using the DCF approach at all when valuing an income stream which isso “dynamic”. Indeed, one of the valuers considered that the DCF approach was moreof a marketing tool and that there was much post hoc rationalisation of the discountrate to support the valuation figure previously thought of!

5.2.2 Lenders. None of the lenders insisted on a particular method of valuationalthough there was a clear expectation that a DCF approach would be undertakenunless the hotel was in the life style sector and turnover depended on the input of keyindividuals such as a husband and wife. All three lenders emphasised that cash flowwas the key lending criteria, with income cover being more important than loan to

Preferred method Cross check

Valuer SalesEarningsmultiplier DCF

Combination of all threeto check valuation

A U U U 5 year DCF U

B U U 10 year DCF U

CU

Only used as part of adevelopment appraisal

U

D U U 10 year DCF U

E U U Cross check only U

F U 10 year DCF U

G U U 10 year DCF U

H U U 10 year DCF U

I U U 5 year DCF U

J U U 10 year DCF U

Table I.Primary methods ofvaluation employed

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value ratio. Each bank had different lending criteria with loan to value ratios rangingfrom 60 to 90 percent of market value.

5.3 Apportionment5.3.1 Valuers. All of the valuers interviewed expressed deep concern about theaccuracy of apportioning market value between the components of land and buildings,trade fixtures and fittings and the market’s perception of trading potential or goodwill.Indeed, one of the valuers was unwilling to undertake any instruction of this kindbelieving that goodwill could not be measured accurately, while another valuer agreedonly to calculate goodwill on a no-liability basis. This reluctance is consistent withPractice Statement 2.7 of the earlier version of the Red Book (Royal Institution ofChartered Surveyors, 1997) which warned that apportionment is a hypotheticalexercise and that valuers must emphasise to their clients that the individual figures donot represent the market value of the elements. For some valuers an apportionmentcalculation was not a common practice, while others had noticed an increase inrequests, mainly from accountants, stemming from the introduction of FRS15 ontangible fixed assets in March 2000 (ASB, 1999). (FRS 15 permits a choice as to whethertangible fixed assets are stated at cost or at a revalued amount. However, where anenterprise chooses to adopt a policy of revaluing some assets, all assets of the sameclass (function or use) must be revalued. The FRS also contains requirements thatensure that the valuations are kept up to date.)

For those valuers who were willing, albeit reluctantly, to apportion the value, thepreferred method of calculating goodwill was to apply a multiplier in the range of1-1.75 to the adjusted net profit (see worked example in Section 6). This range appearedhighly subjective. One valuer mentioned an approach similar to the bridge modeloutlined in Section 4.4 above, where comparison is made between the value of anestablished business and a new business venture. In order to ensure transparency andconsistency, support was expressed for some guidance from the RICS, perhaps in theform of an information paper, on the appropriate methodology to be employed in thecalculation of goodwill. Indeed, one valuer thought that it might be possible to achievea European and internationally recognised way of calculating goodwill, but that theRICS needed to play a central role for this to be achieved. In the absence of clearguidelines, there was no consensus among the valuers that internally generatedgoodwill could be measured reliably and thus no clear mandate to change FRS10.

5.3.2 Lenders. None of the lenders required an apportionment between land andbuildings, fixtures and fittings and goodwill. One of the lenders commented that theywere not concerned about goodwill unless the operator was inexperienced and cashflow was at risk, and that in any event they did not believe that internally generatedgoodwill could be measured reliably. This disregard for the components of valueappears surprising, given the generally held view that intangible assets are more riskyand have less debt capacity. Where a business is in financial difficulty, the goodwillvalue may well have deteriorated to such an extent that there is little recoverable value.At that point, the lender is primarily concerned with recovery of the principal amountof the loan and often looks to sell the tangible assets as soon as possible. It wastherefore expected that the lenders would wish to apportion the value to correctlyquantify the risk.

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5.4 RiskIn an attempt to understand the key risk factors that drive yield adjustment in the hotelsector, the valuers were asked to rank the significance of different categories ofpotential risk in the context of valuing two typical hotel types:

(1) Hotel A. Provincial hotel, located in the centre of a medium sized city. Groupowned with modern facilities and fully licensed.

(2) Hotel B. Country hotel situated in a popular tourist area. Privately owned withmodern facilities and fully licensed.

The risk categories were identified by Rushmore and Baum (2001) and outlined inSection 4.3. A score of 1 indicated most risk while a score of 6, least risk. The scoreswere aggregated and Table II shows the resultant ranking of the different types of risk.

From Table II it can be seen that in valuing both types of hotel, the key risk factorwas considered to be general risk of being in the hotel sector as compared with otherparts of the property market. The risk associated with the leisure industry is wellillustrated by the London market post 11 September 2001, where occupancy levelshave been severely affected by the downturn in US visitors. Management risk andspecific locational factors also scored highly, while functional obsolescence wasconsidered to have least significance as a risk factor.

All of the valuers agreed that the level of risk under the various headings, variedover time. (Currently, the threat of global terrorism has increased the probability ofhotels suffering a reduction in income flow and, consequently increased the riskassociated with investing in hotels.) Furthermore, there was consensus among thevaluers that profits in the hotel sector have fluctuated over the last ten years. With thisin mind, the valuers were asked to consider whether the yields used to capitalise theadjusted net profit into perpetuity had, over the last ten years, fully reflected thefluctuating nature of the risk attached to cash flow. Theory would suggest that thehigher the expected risk, the higher the capitalisation yield (Hoesli and MacGregor,

Categories of risk Example Hotel A Hotel B

+General sector risk Risks associated with the hotel sectorgenerally, i.e. fuel crisis, “foot and mouth”outbreak and 11 September 1 1

+Management risk Risks associated with assembling staff tooperate business 3 2

+Food and beverage risk Risks associated with“non-accommodation” aspects of business,i.e. restaurants, leisure etc. 4 3

+Rapid functional obsolescence High level of depreciation attributed tonon-property assets, i.e. fixtures andfittings 5 = 6

+Lack of liquidity Business cannot be sold in small lots 5 = 4 =+Other elements That is parking, Disability Act, repairs,

existing structural condition, competition,design, location, willingness of banks tofinance category of hotel 2 4 =

Source: Adapted from Rushmore and Baum (2001)Table II.

Risk in hotel valuations

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2000). Interestingly, there was no consensus among the valuers as to whether yields inthe hotel sector have fully reflected any underlying shift in risk. Some valuers arguedthat yields have moved significantly while others believed that the range of movementhas been narrow. Unfortunately data on yields could not be made available for reasonsof commercial confidentiality.

One valuer, operating in the Scottish market, commented that multipliers of theadjusted net profit had remained steady over the last ten years at between 5 and 7.Several valuers questioned whether there was a danger of double counting ifadjustment was made to both adjusted net profit and yield. In other words, it wassuggested that all the risk was built into the cash flow, with the yield remainingrelatively constant so that the earnings change was sufficient to reflect changes inmarket price. The counter argument is that by only adjusting the cash flow projectionthe risk attached to the receipt of the income is ignored.

One valuer commented that the valuation of hotels was quite different to valuing anoffice, as hotel profits were not fixed between reviews. Further comment was made thatthe hotel valuation profession was immature and less sophisticated than thecommercial property market and less influenced by financiers.

5.5 Accounting and taxation issuesQuestions concerning five broad issues were addressed to the participating accountant.First, he was asked how the apportionment of hotel valuation between the differentelements of land and buildings, fixtures and fittings and “trading potential” (orgoodwill) was typically achieved in practice. He confirmed that the allocation wasachieved by negotiation between the parties to the transaction, as part of the overalldeal. If a group of hotels (or a single hotel company) was being sold then goodwill onacquisition (purchased goodwill) would be the difference between the purchase priceand the fair value[3] of tangible assets acquired. The fair value of each hotel would bebased on its characteristics including “trading potential”/goodwill, which would not beseparately identified. The purchased goodwill element would represent any excessvalue of the group of hotels arising from management expertise, marketing orbranding. If the sale was “an asset deal” then typically the purchase price would beallocated between the tangible assets with no allocation to “tradingpotential”/goodwill. Taxation would impact on the allocation between tangibleassets via concerns about stamp duty, VAT and capital allowances.

The second question asked for views on whether or not “trading potential”/goodwillshould be split out from the overall valuation. He tended to agree with the logic ofFRS15 that such trading potential attaches to the asset itself and is inherentlyinseparable. He suggested that the situation was similar to the treatment of a gaminglicence as part of the value of a dog track. In theory, the track could be split into itsvarious components of grandstand, land and other buildings and gaming licence.However, the all-important licence would be treated as part of the value of the wholesince its value derived from the gaming track.

Third, for a single hotel company transaction, there is often the option to treat thetransaction as the purchase of either an asset (typically no separate goodwill element)or of a company (with an element of purchased goodwill). The accountant suggestedthat the choice would depend on the specific situations faced by buyer and seller. A“company” deal can sometimes reduce some asset-based taxes (e.g. stamp duty) but the

JPIF22,3

248

buyer takes on an (uncertain) liability of the company’s history; an “asset” deal iscleaner.

Fourth, the accountant was asked if there were any other issues relating to thevaluation of hotels that cause accounting problems. He suggested that the FRS15requirement to adjust the carrying value of assets for impairment was creatingconcerns for many companies with assets, such as hotels, sensitive to post 11September issues. Also, the need to adopt international accounting standards by 2005was causing serious concern for companies carrying assets at revalued amounts. Theproblem is that the international standard does not currently allow revalued amountsto be frozen as “cost” carrying values, though this may change in the “first timeapplication” of international standards rules. Otherwise, companies may incuradditional costs in reverting to original historical cost or in meeting the requirement torevalue the assets regularly.

Finally, views were requested on the current distinction between the treatment ofpurchased and of internally-generated goodwill. He agreed that the distinction isinconsistent and reduces comparability between companies, sometimes quite seriously.However, he argued that there is a good distinction between the two. Purchasedgoodwill has been valued in the market place but internally-generated goodwill hasnot; it is not a realised value. He also suggested that the previous practice of writing offpurchased goodwill against reserves was not appropriate; he believed that treatinggoodwill as an asset, on-balance sheet, requiring amortisation makes more sense.

The main thrust of the arguments put forward by the participating tax consultantwas that recent tax changes are already creating much more interest amongst propertybuyers in allocating part of the value to goodwill. He suggested that neither theprofessions nor the Inland Revenue appear to be geared up to cope with the valuationissues and that there is an urgent need for sensible guidelines. He highlighted some ofthe recent relevant tax changes. For example, goodwill and other intellectual propertyrights are currently exempted from stamp duty. With a top rate of 4 percent, the stampduty savings can be very large and “this is already creating some ‘ridiculous’apportionments being sought by some purchasers”; this is likely to create difficultieswith the Inland Revenue. Relief for the purchase price of goodwill against corporationtax is at present possible; the provisions are complex but, where applicable, relief willbe available for the annual amortisation of goodwill. He also identified the tension inlisted companies between tax savings and reported profits. While goodwillamortisation may reduce taxation, it also reduces reported profits and this mayimpact on market perceptions of the company. Unlisted companies may not suffer suchdisincentives and may favour the taking of goodwill on the balance sheet.

In summary, the interviewees confirmed that both accounting and taxation issuesare leading to greater pressure to find acceptable methods for the allocation of propertyvalues between tangible and intangible (including goodwill) elements.

6. A case study example of valuation practiceIn this section, we review the various valuation methodologies using a hotel valuationas a case study. The valuations are based upon the example presented in Table III. Theexample[4] is a modern purpose-built four star provincial hotel, having 120 lettingbedrooms with well-planned, flexible accommodation including restaurant, bar,conference rooms and leisure club. The property is easily accessible and has good car

Trade-relatedvaluations

249

Forecastyear

1yearpast

2years

past

3years

past

nPercentof

gross

nPercentof

gross

nPercentof

gross

nPercentof

gross

Number

ofroom

s120

120

120

120

Occupancy

0.76

0.75

0.74

0.76

Occupiedroom

s33,288

32,850

32,412

33,288

Averagerate

(£)

62.67

61.14

59.65

58.20

Revenue(£)

Rooms

2,086,159

452,008,497

451,933,383

451,937,206

45Food

1,622,568

351,562,164

351,503,742

351,506,716

35Beverage

602,668

13580,232

13558,533

13559,637

13Telephone

92,718

289,267

285,928

286,098

2Other

231,795

5223,166

5214,820

5215,245

5Total

4,635,909

100

4,463,327

100

4,296,406

100

4,304,902

100

Departmentalcostsandexpenses(£)

Rooms

625,848

30602,549

30580,015

30581,162

30Foodandbeverage

1,335,142

601,285,438

601,237,365

601,239,812

60Telephone

37,087

4035,707

4034,371

4034,439

40Other

104,308

45100,425

4596,669

4596,860

45Total

2,102,385

452,024,119

451,948,420

451,952,273

45Undistributedoperatingexpenses(£)

General

admin.

440,411

9.5

424,016

9.5

408,159

9.5

408,966

9.5

Marketing

115,898

2.5

111,583

2.5

107,410

2.5

107,623

2.5

Property

operationand

maintenance

185,436

4.0

178,533

4.0

171,856

4.0

172,196

4.0

Energy

162,257

3.5

156,216

3.5

150,374

3.5

150,672

3.5

Total

904,002

19.5

870,349

19.5

837,799

19.5

839,456

19.5

Incomebeforefixed

charges

1,629,522

1,568,859

1,510,187

1,513,173

Fixed

expenses(£)

Rates

92,718

289,267

285,928

286,098

2Insurance

23,180

0.5

22,317

0.5

21,482

0.5

21,525

0.5

Reserveforreplacement

231,795

5223,166

5214,820

5215,245

5Total

347,693

334,750

322,230

322,868

Adjusted

net

profit

1,281,829

1,234,110

1,187,956

1,190,305

Table III.Current and forecasttrading performance

JPIF22,3

250

parking facilities. The hotel is heavily reliant on corporate business and conferencetrade during the week with some leisure-based trade at weekends.

The audited accounts, prepared in the format outlined in the Uniform System ofAccounts for the Lodging Industry, for the last three years are presented in theTable III.

6.1 Earnings multiplier approachWhen applying the simple earnings multiplier approach to determine value, thevaluer analyses and reviews the trading accounts for the current and previous years,typically over a period of at least three years. The valuer should then form anopinion, by reference to analysis of trading accounts of comparable properties, as tothe future trading performance and the fair, maintainable operating profit (oradjusted net profit) likely to be achieved by a competent operator. This is representedin Table III.

To determine the market value, the adjusted net profit is capitalised in perpetuityusing a yield determined from comparable evidence. As noted earlier, this yield shouldreflect the valuer’s opinion of the market’s perception of risk associated with theoperational entity, considering all available market evidence and economic factors. Thevaluation is represented in Table IV.

The determination of the value of the business enterprise value or goodwill, whenusing the earnings multiplier approach, is typically determined by applying amultiplier, in the range of 1.0-1.75, to the adjusted net profit. This is shown in Table V.(This multiplier is not typically considered as YP in perpetuity at 80 percent, but thiseffectively is what it means. Arguably a high yield is required to compensate for thehigh risk associated with this component of the market value.)

Assuming a multiplier of 1.25 the estimated value of the goodwill is approximately£1,600,000. Clearly the choice of multiplier is subjective and highly sensitive. Forexample, using a multiplier of 1.5 would produce a figure of £1,900,000.

6.2 Discounted cash flow approachThe DCF approach is based on the same principle as the earnings multiplier approach.The valuer analyses and reviews current and past trading performance and forecastsfuture trading levels, assuming that the business is run by a competent operator (thesame process as the simple earnings multiplier approach). The difference with thismethod is that the income is projected over a longer time frame, typically five to ten

Adjusted net profit £1,281,829YP perp at 12.5 percent 8Capital value £10,254,630Say £10,250,000

Table IV.Earnings multiplier

approach

Adjusted net profit £1,281,829YP 1.25Goodwill £1,602,286

Table V.Determination of

goodwill

Trade-relatedvaluations

251

years, explicitly allowing for income growth or decline. Our research found that, at thetime of writing, the growth rate adopted for an established business tended to be closeto the rate of inflation, which for the purposes of illustration is assumed to be 2.5percent per annum. The example adopts a constant inflation rate, but clearly thismethod allows for a variety of assumptions to be made when projecting future cashflows. At the end of the holding period the projected adjusted net profit is capitalisedassuming a sale yield. The projected cash flow for the example above, over a ten-yearperiod is shown in Table VI.

To determine the market valuation the projected adjusted net profit figures alongwith the exit value are discounted using an equated yield (14.5 percent). Once againthis yield should reflect the valuer’s opinion of the market’s perception of riskassociated with the operational entity, considering all available market evidence andeconomic factors.

Using the forecast income, the valuation is shown in Table VII. The valuation figureis estimated at £10,500,000, a similar value to that calculated using the earningsmultiplier approach. The similarity of the valuation figures is not surprising, giventhat an equated yield of 14.5 percent, combined with an initial yield of 12.5 percent,produces an implied annual growth rate of 2.54 percent, which is almost identical to thegrowth rate adopted by the valuers of 2.5 percent, which represented their view on therate of inflation and the likely growth of turnover. The valuers did not need to adoptthe inflation rate as their growth rate. The DCF approach allows for a range of possibleinputs which enables the valuer to fine tune his/her opinion on business growth.

To determine the value of the goodwill using the “Bridge model”, a comparison ismade between the forecast income flow of an established business and that of a newbusiness, assuming that the property is vacant and fully equipped for business but notyet trading. The forecast income flow is shown in Table VIII.

This projected income flow is discounted in the manner described above with anadjusted equated yield (16 percent) to reflect the higher risk of establishing a newbusiness. This yield is applied to the income flow throughout the ten-year holdingperiod. The model would easily allow for multiple discount rates, as the level of riskchanges. For example, after year 4 when the revenues stabilise, the rate adopted couldrevert to the yield used when valuing the established business. The valuation is shownin Table IX.

The estimated value of the goodwill is the difference between the valuations of anestablished business and the valuation of a new business. In this case, the goodwillvalue would be estimated to be approximately £1,800,000 (£10,500,000-£8,700,000).This compares with £1,600,000 using the “rule of thumb” multiplier applied to theadjusted net profit approach, assuming the valuer had used a multiplier of 1.25 – ahighly subjective choice. However, the bridge model produces a figure that arguably isderived in a more explicit, robust and theoretically sound basis.

7. ConclusionEvidence from our research would suggest that valuers use a range of methods toreach the market valuation of corporate hotels. For the majority of valuers the earningsmultiplier approach was the primary method employed where the business wasestablished, with an explicit DCF approach and the sales comparison method used as across check. An explicit DCF approach was the favoured method where a new hotel

JPIF22,3

252

12

34

56

78

910

Number

ofroom

s120

120

120

120

120

120

120

120

120

120

Occupancy

0.76

0.76

0.76

0.76

0.76

0.76

0.76

0.76

0.76

0.76

Occupiedroom

s33,288

33,288

33,288

33,288

33,288

33,288

33,288

33,288

33,288

33,288

Averagerate

(£)

62.67

64.24

65.84

67.49

69.18

70.91

72.68

74.49

76.36

78.27

Revenue(£)

Rooms

2,086,159

2,138,313

2,191,771

2,246,565

2,302,729

2,360,297

2,419,305

2,479,787

2,541,782

2,605,327

Food

1,622,568

1,663,132

1,704,711

1,747,328

1,791,012

1,835,787

1,881,682

1,928,724

1,976,942

2,026,365

Beverage

602,668

617,735

633,178

649,008

665,233

681,864

698,910

716,383

734,293

752,650

Telephone

92,718

95,036

97,412

99,847

102,344

104,902

107,525

110,213

112,968

115,792

Other

231,795

237,590

243,530

249,618

255,859

262,255

268,812

275,532

282,420

289,481

Total

4,635,909

4,751,807

4,870,602

4,992,367

5,117,176

5,245,105

5,376,233

5,510,639

5,648,405

5,789,615

Departmentalcostsandexpenses(£)

Rooms

625,848

641,494

657,531

673,970

690,819

708,089

725,791

743,936

762,535

781,598

Foodandbeverage

1,335,142

1,368,520

1402,733

1,437,802

1,473,747

1,510,590

1,548,355

1,587,064

1,626,741

1,667,409

Telephone

37,087

38,014

38,965

39,939

40,937

41,961

43,010

44,085

45,187

46,317

Other

104,308

106,916

109,589

112,328

115,136

118,015

120,965

123,989

127,089

130,266

Total

2,102,385

2,154,944

2,208,818

2,264,038

2,320,639

2,378,655

2,438,122

2,499,075

2,561,552

2,625,590

Undistributedoperatingexpenses(£)

General

admin.

440,411

451,422

462,707

474,275

486,132

498,285

510,742

523,511

536,598

550,013

Marketing

115,898

118,795

121,765

124,809

127,929

131,128

134,406

137,766

141,210

144,740

Property

operationand

maintenance

185,436

190,072

194,824

199,695

204,687

209,804

215,049

220,426

225,936

231,585

Energy

162,257

166,313

170,471

174,733

179,101

183,579

188,168

192,872

197,694

202,637

Total

904,002

926,602

949,767

973,512

997,849

1,022,796

1,048,365

1,074,575

1,101,439

1,128,975

Incomebeforefixed

charges

1,629,522

1,670,260

1,712,016

1,754,817

1,798,687

1,843,655

1,889,746

1,936,990

1,985,414

2,035,050

Fixed

expenses(£)

Rates

92,718

95,036

97,412

99,847

102,344

104,902

107,525

110,213

112,968

115,792

Insurance

23,180

23,759

24,353

24,962

25,586

26,226

26,881

27,553

28,242

28,948

Reservefor

replacement

231,795

237,590

243,530

249,618

255,859

262,255

268,812

275,532

282,420

289,481

Total

347,693

356,385

365,295

374,428

383,788

393,383

403,217

413,298

423,630

434,221

Adjusted

net

profit

1,281,829

1,313,875

1,346,721

1,380,389

1,414,899

1,450,272

1,486,528

1,523,692

1,561,784

1,600,829

Anticipated

growth

rate

(%)

2.5

Table VI.Ten-year income andexpenditure forecast

Trade-relatedvaluations

253

development was being valued or a major refurbishment planned. Some significantdifferences in the implementation of these methods were noted, particularly withregard to the holding period and the rationale used in selecting the discount rate.

The research found considerable disquiet and unease about the accuracy ofapportioning the market value in order to calculate goodwill. Practice ranged fromoutright refusal to undertake such an instruction, to the application of a “rule ofthumb” multiplier to the adjusted net profit, with the resulting figure being subject toconsiderable caveats. There was no consensus on how (or if) goodwill could bemeasured reliably; further guidance from RICS on appropriate methodology wasconsidered to be of crucial importance. This paper has illustrated the application of thebridge model which is recommended as a theoretically sound and robust approach tovaluing goodwill.

Accounting changes in recent years have increasingly recognised the importance ofintangible assets such as intellectual capital and goodwill. Similarly, recent taxchanges demonstrate the government’s acceptance of the importance of such items inachieving and maintaining business competitiveness. However, accounting standardshave been reticent in encouraging the reporting of intangibles on companies’ balancesheets unless a reliable (usually market) value can be demonstrated. This reticencelargely reflects a belief that the art of valuing intangibles is insufficiently developed toproduce reliable results. This situation does not seem to be sustainable in the long-termand if accounting is to provide useful information for decision-making, the valuationissue needs to be addressed. Further tax changes, such as the increasing rates of stampduty, have heightened the need for a robust and defensible valuation methodology.

An information paper on trade-related valuations is due to be published by the RICSand early publication of this paper is to be encouraged. The paper should include clearand concise guidance on the methodology to be adopted when preparing trade-relatedvaluations and apportioning value between land and buildings, fixtures and fittingsand goodwill.

From this research there is evidence to suggest that the investment market forcorporate hotels is, to a degree, naı̈ve and that, while explicit changes are made to the

Year Adjusted net profit (£) PV of £1 DCF (£)

01 1,281,829 0.8734 1,119,5012 1,313,875 0.7628 1,002,1733 1,346,721 0.6662 897,1424 1,380,389 0.5818 803,1195 1,414,899 0.5081 718,9496 1,450,272 0.4438 643,6017 1,486,528 0.3876 576,1498 1,523,692 0.3385 515,7679 1,561,784 0.2956 461,71210 14,407,457 0.2582 3,719,910Capital value 10,458,023Say 10,500,000Sale yield (%) 12.5Equated yield (%) 14.5

Table VII.Ten-year DCF for anestablished business

JPIF22,3

254

12

34

56

78

9

Number

ofroom

s120

120

120

120

120

120

120

120

120

Occupancy

0.65

0.68

0.72

0.76

0.76

0.76

0.76

0.76

0.76

Occupiedroom

s28,470

29,784

31,536

33,288

33,288

33,288

33,288

33,288

33,288

Averagerate

(£)

55.50

56.89

59.73

62.72

65.85

67.50

69.19

70.92

72.69

Revenue(£)

Rooms

1,580,085

1,694,337

1,883,704

2,087,772

2,192,161

2,246,965

2,303,139

2,360,718

2,419,736

Food

1,228,955

1,317,818

1,465,103

1,623,823

1,705,014

1,747,639

1,791,330

1,836,114

1,882,017

Beverage

456,469

489,475

544,181

603,134

633,291

649,123

665,351

681,985

699,035

Telephone

70,226

75,304

83,720

92,790

97,429

99,865

102,362

104,921

107,544

Other

175,565

188,260

209,300

231,975

243,573

249,663

255,904

262,302

268,860

Total

3,511,300

3,765,194

4,186,010

4,639,494

4,871,469

4,993,256

5,118,087

5,246,039

5,377,190

Departmentalcostsandexpenses(£)

Rooms

474,026

508,301

565,111

626,332

657,648

674,090

690,942

708,215

725,921

Foodandbeverage

1,011,254

1,084,376

1,205,571

1,336,174

1,402,983

1,438,058

1,474,009

1,510,859

1,548,631

Telephone

28,090

30,122

33,488

37,116

38,972

39,946

40,945

41,968

43,018

Other

79,004

84,717

94,185

104,389

109,608

112,348

115,157

118,036

120,987

Total

1,592,375

1,707,515

1,898,355

2,104,011

2,209,211

2,264,441

2,321,052

2,379,079

2,438,556

Undistributedoperatingexpenses(£)

General

admin.

333,574

357,693

397,671

440,752

462,790

474,359

486,218

498,374

510,833

Marketing

87,783

94,130

104,650

115,987

121,787

124,831

127,952

131,151

134,430

Property

operationand

maintenance

140,452

150,608

167,440

185,580

194,859

199,730

204,723

209,842

215,088

Energy

122,896

131,782

146,510

162,382

170,501

174,764

179,133

183,611

188,202

Total

684,704

734,213

816,272

904,701

949,936

973,685

998,027

1,022,978

1,048,552

Incomebeforefixed

charges

1,234,222

1,323,466

1,471,382

1,630,782

1,712,321

1,755,129

1,799,008

1,843,983

1,890,082

Fixed

expenses(£)

Rates

70,226

75,304

83,720

92,790

97,429

99,865

102,365

104,921

107,544

Insurance

17,557

18,826

20,930

23,197

24,357

24,966

25,590

26,230

26,886

Reserveforreplacement

175,565

188,260

209,300

231,975

243,573

249,663

255,904

262,302

268,860

Total

263,348

282,390

313,951

347,962

365,360

374,494

383,857

393,453

403,289

Adjusted

net

profit

970,874

1,041,076

1,157,432

1,282,820

1,346,961

1,380,635

1,415,151

1450,530

1,486,793

Table VIII.Ten-year income and

expenditure forecast fornew business

Trade-relatedvaluations

255

cash-flow projections, there is insufficient appreciation of the changing risk profilewhich might lead to an adjustment to the multiplier.

This criticism is at present new to the industry, as the Investment PropertyForum/Investment Property Databank (2000) highlighted the need for more rigorousrisk assessment measures within the property profession. More specifically, theyconcluded that a new approach is needed which combines conventional analysis ofreturns uncertainty with a more comprehensive survey of business risks. The presentresearch supports these initiatives and suggests the value of comparing hotel yieldsover time against other investment market risk indicators. Unfortunately, it was notpossible to secure the data on hotel transactions due to commercial confidentialityagreements.

No research report in this area would be complete without some comment on theopaque nature of the property industry. This is equally true of the leisure industry andthe hotel sector where there is little published data on transaction and investmentperformance which, in turn, may discourage investment in the sector.

This research has focused on the corporate hotel sector as an illustrative case study.The findings have wider implications for other sectors of the market where operationalentities are valued with regard to their trading potential. The concerns raised aboveabout the correct appreciation and pricing of cash flow risk may well have resonance inother sectors of the property market. The trade-related valuation of any type ofbusiness involves looking forward in time and estimating a cash flow profile that isdynamic and potentially much more volatile than standard property investmentofferings.

Notes

1. IRC v. Muller & Co Margarine Limited (1901) AC217.

2. A recent study of UK investment analysts and company finance directors suggested thatthey share this view. A small number of interviewees were against the introduction of formalreporting requirements for intangibles, including increased recognition of intangibles oncompany balance sheets (Vance, 2001).

Year Adjusted net profit (£) PV of £1 DCF (£)

01 970,874 0.8621 836,9612 1,041,076 0.7432 773,6893 1,157,432 0.6407 741,5184 1,282,820 0.5523 708,4905 1,346,961 0.4761 641,3066 1,380,635 0.4104 566,6717 1,415,151 0.3538 500,7228 1,450,530 0.3050 442,4499 1,486,793 0.2630 390,95710 13,715,666 0.2267 3,109,117Capital value 8,711,878Say 8,700,000Sale yield (%) 12.5Equated yield (%) 16.0

Table IX.Ten-year DCF for a newbusiness

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3. When a subsidiary company is acquired by a group, the general accounting principle is thatthe subsidiary’s assets should be taken into the group at their fair value rather than bookvalue. FRS 7 (para 2) defines fair value as: “The amount at which an asset or liability couldbe exchanged in an arm’s length transaction between informed and willing parties, otherthan in a forced or liquidation sale” (ASB, 1994).

4. Average room rate and occupancy are derived from market research unertaken by TRIHospitality Consulting.

References

Accounting Standards Board (ASB) (1994), FRS 7: Fair Values in Acquisition Accounting, ASB,London.

Accounting Standards Board (ASB) (1997), FRS 10: Goodwill and Intangible Assets, ASB,London.

Accounting Standards Board (ASB) (1999), FRS 15: Tangible Fixed Assets, ASB, London.

Appraisal Institute (1993), The Dictionary of Real Estate Appraisal, 3rd ed., Appraisal Institute,Chicago, IL.

Arnold, J., Egginton, D., Kirkham, L., Macve, R. and Peasnell, K. (1994), Goodwill and OtherIntangibles: Theoretical Considerations and Policy Issues, ICAEW, London.

Benson, M. (1999), “Real estate and business value: a new perspective”, Appraisal Journal, Vol. 67No. 2, pp. 205-12.

Canibano, L., Garcia-Ayuso, M. and Sanchez, P. (2000), “Accounting for intangibles: a literaturereview”, Journal of Accounting Literature, Vol. 19, pp. 102-30.

Clark, S. and Knight, J. (2002), “Business enterprise value in special purpose properties”, TheAppraisal Journal, Vol. 70 No. 1, pp. 53-9.

Egginton, D. (1990), “Towards some principles for intangible asset accounting”, Accounting andBusiness Research, Vol. 20 No. 79, pp. 193-205.

Estates Gazette (1994), RICS Vetoes BAHA Advice, Estates Gazette, London, April.

Hoesli, M. and MacGregor, B.D. (2000), Property Investment: Principles and Practice of PortfolioManagement, Pearson Education Ltd, London.

International Accounting Standards Committee (IASC) (1998), IAS 38: Intangible Assets, IASC,London.

Inland Revenue (2001), Technical Note of 7 March 2001, Inland Revenue, London.

Investment Property Forum/Investment Property Databank (2000), The Assessment andManagement of Risk in the Property Investment Industry, Investment PropertyForum/Investment Property Databank, London.

Lennhoff, D. (1999), “Business enterprise value debate: still a long way to reconciliation”,Appraisal Journal, Vol. 67 No. 3, pp. 422-8.

Ma, R. and Hopkins, R. (1988), “Goodwill – an example of puzzle-solving in accounting”, Abacus,Vol. 24 No. 1, pp. 75-85.

Marshall, H. and Williamson, H. (1996), Law and Valuation of Leisure Property, Estates Gazette,London.

Rabianski, J. (1996), “Going-concern value, market value and intangible value”, The AppraisalJournal, Vol. LXIV No. 2, pp. 183-94.

Rees, W. and Hayward, R. (2000), Valuation: Principles into Practice, Estates Gazette, London.

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Royal Institution of Chartered Surveyors (1997), Appraisal and Valuation Manual, RoyalInstitution of Chartered Surveyors, Incorporated Society of Valuers and Auctioneers andInstitute of Revenues Rating and Valuation, London.

Royal Institution of Chartered Surveyors (2003), RICS Appraisal and Valuation Standards, RoyalInstitution of Chartered Surveyors, Coventry.

Rushmore, S. and Baum, E. (2001), Hotels and Motels: Valuation and Market Studies, AppraisalInstitute, Chicago, IL.

Stolowy, H. and Jeny-Cazavan, A. (2001), “International accounting disharmony: the case ofintangibles”, Accounting, Auditing & Accountability Journal, Vol. 14 No. 4, pp. 477-96.

Vance, C. (2001), Valuing Intangibles, ICAEW, London.

Appendix. List of the companies who assisted in the researchValuersAtis Real WeatherallsChestertonChristie & CoEdward Symmons & PartnersFPD SavillsHVS InternationalInsignia Hotel LtdKnight FrankMatthews GoodmanRobert Barry & Co

LendersBank of ScotlandBarclaysRoyal Bank of Scotland

Accountants/consultantsOne of the Big 4 accounting firmsMcCabes

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