Practice note 4/3: Alternative methods of assessing compensation for trade disturbance
The Valuation Office Agency`s technical manual covering all aspects of compulsory purchase and compensation.
1 Introduction
The assessment of compensation for trade disturbance is subject to the same broad principles as the assessment of any other type of disturbance in cases of compulsory purchase. The principles were restated in Director of Buildings and Lands v Shun Fung Ironworks Limited [1995] RVR 124 in which it was confirmed that the claimant’s losses must be assessed with regard to causation, remoteness and mitigation. In other words the claimant’s losses
- must be a direct and reasonable consequence of the acquisition
- must not be too remote and
- the claimant must have attempted to mitigate his loss where possible.
The method of assessment of compensation for trade disturbance has traditionally been undertaken by multiplying the annual net profits of a business, usually an average of the last three years’ profits before dispossession, suitably adjusted for rent and interest on capital, by a multiplier or Years’ Purchase (YP) to arrive at a capital sum. This sum has been taken to represent the value of the business to the claimant on the principle that disturbance compensation is assessed on the basis of ‘value to owner’ not ‘open market value’.
A typical calculation would look as follows:
| Annual average net profit for the last three years | £75,000 |
| Less: |
| Notional rent (where property owner occupied) | £15,000 | ||
| Interest on capital | |||
| Stock | £25,000 | ||
| Fixtures & fittings | £10,000 | ||
| Cash in hand | £2,000 | ||
| £37,000 | |||
| @ 5% | £1,850 | £16,850 | |
| £58,150 | |||
| Years’ Purchase | 2.5 | ||
| £145,375 | |||
| Say | £145,000 |
However, in recent years alternative approaches to the assessment of compensation for trade disturbance have been adopted in larger or more complex cases.
2.1 The ‘Optical Express’ case
In Optical Express (Southern) Ltd v Birmingham City Council [2005] RVR 230 the Tribunal said of this traditional approach ‘There is a lack of market evidence, and the figure of YP is usually fixed by reference to settlements and decisions of the Tribunal, which become self-perpetuating within a particular range without any guidance or check from the market’.
2.2 Background
The ‘Optical Express’ case involved the acquisition of a shop in a 1960s shop and office development that suffered from poor layout, design and appearance. The shop was acquired for redevelopment as part of a scheme undertaken by an organisation called the Birmingham Alliance and comprised the Martineau Galleries development. It was to be developed in three phases named Martineau Phase 1, Martineau Phase 2 and the Bull Ring.
One of the principle issues in the case was the method by which trade disturbance for total extinguishment should be assessed.
The claimants sought total compensation of £1,727,231 and the acquiring authority offered £398,900. The Tribunal’s decision amounted to £570,920 in total.
2.3 Case procedure
The Tribunal’s consideration of post-dispossession (post entry) losses was where completely new ideas were introduced regarding the assessment of compensation for loss of profits.
The Tribunal referred a number of times to the Bwllfa principle whereby valuers are entitled to have regard to events that occur after the valuation date in order to assist in the assessment of compensation.
There was a large measure of agreement between the parties and both employed forensic accountants to assess the compensation. They were agreed that the value of the business should be assessed by means of an earnings multiplier to assess the value of the business as a whole and from that figure the capital value of the property should be deducted because compensation for it would be assessed separately under Rule (2). They were also agreed that the ‘value to owner’ was fairly represented by the market value of the business and that the compensation should be assessed on the basis of total extinguishment.
Two main approaches were adopted, both of which the parties agreed were valid.
2.4 Claimant’s approach
The claimants’ accountant’s approach was to take the ‘branch contribution’ which comprised the gross profit less staff costs, property overheads and other charges, less tax, and apply a Price/Earnings (P/E) multiplier to arrive at the value of the business.
The Price/Earnings ratio (or multiplier) is the market price of a share divided by its earnings. It is the most commonly used measure of the value of a share. ‘Earnings’ in this context means the net profit of a company that is available for distribution to its shareholders or for placing in the reserves and is therefore taken after the deduction of tax.
The claimants’ accountant had found no comparable UK quoted companies with characteristics of the claimant company and therefore arrived at the P/E multiplier by looking at P/E ratios for the largest quoted opticians being Dolland & Aitchison (33.9), Vision Express (20.3) and Boots (12.8). She also had regard to the Financial Times Actual Share Index for general retailers of 16.2 in April 2000, which she adopted as her starting point. She then deducted between 35% to 40% to reflect the unlisted status, smaller size and lower diversity of the claimant’s company (generally referred to as ‘illiquidity’) but then added between 15% and 20% to reflect that the entire business was being acquired, not merely a shareholding in it, so the that hypothetical purchaser would have complete control of it (the ‘control premium’). She derived the appropriate percentage from a perusal of ‘Acquisitions monthly’.
2.5 The acquiring authority’s approach
The acquiring authority’s accountant took as his starting point the EBITDA (Earnings Before Interest Tax Depreciation and Amortisation) of the claimant company. EBITDA is used as a ‘rule of thumb’ measure of a company’s maintainable cash generating capability and, by implication, its ability to service its debt. The argument is that, because depreciation and amortisation are non-cash charges, they should not be excluded from any measure of a company’s future ability to generate cash and service its debt. ‘Depreciation’ refers to the writing down of a company’s tangible assets (eg motor vehicles) over time and ‘Amortisation’ refers to the writing down of a company’s intangible assets (eg goodwill, key money, capitalised charges) to a ‘nil’ value over a period of years.
The acquiring authority’s accountant applied an appropriate multiplier, derived from an analysis of the value of five European companies because no UK companies were closely comparable to Optical Express. He took the average of the EBITDA multiplier of the five being 9.9 and adopted that as his base multiple. He also used the EBITDA multiplier derived from sale prices of three European companies as a check. He then applied the multiplier to the EBITDA of the claimant company. He made a deduction from the EBITDA multiplier of 40% to 50% to reflect the company’s unlisted status but he made no addition to reflect that the purchaser would be gaining control (‘control premium’).
2.6 Lands Tribunal’s decision
The Lands Tribunal criticised the claimants’ accountant’s general approach. There was no agreed valuation date and she had assessed the post-dispossession losses as from 2003 instead of 2000. The Tribunal determined the valuation date as 7 April 2000, being the date of vesting. The Tribunal made it clear that any losses occurring after the valuation date would need to be discounted back to that date. This created more uncertainty in the calculation: first the future turnover had to be projected up to 2003 and then discounted back to 2000.
The choice of a P/E multiple to assess the value of the business was also not the Tribunal’s choice. There are various disadvantages and uncertainties with P/E ratios. They are based on investors’ estimates of future profitability but have regard to historic earnings. For example, if a company’s earnings per share were currently £1 per annum and the share price was £20 the P/E ratio would be 20. If investors believed that future years’ earnings per share would be £2 per annum, the share price would rise accordingly to reflect that. The share price might thus rise to £40 but the historic earnings, upon which the P/E ratio is based, would remain at £1. The P/E ratio for that company would thus appear as 40, which would be untypical for that sector and would distort the sector average P/E ratio.
As the meaning of ‘earnings’ for the purposes of P/E refers to a company’s net after tax profits, these could be influenced by the particular taxation characteristics of the company under consideration and might produce varying figures. For example, a company with large tax losses carried forward would pay less corporation tax than another company. Similarly, a company with a high level of debt would reflect a large interest charge in its net profit and this would affect its P/E ratio. The P/E for that sector applied to the net earnings of the business would thus not reflect the underlying worth of the business.
For these reasons, the Lands Tribunal rejected the use of a P/E multiple in favour of an EBITDA multiplier applied to the EBITDA. It also preferred the use of an EBITDA multiple because its use is more widespread being used in Western Europe and the USA and thus the evidence was drawn from a wider base. The multiple in this case was derived from a review of typical multiples for companies in the optical sector. The Tribunal determined that the appropriate multiplier was 11 from which it deducted 40% to reflect the private company status of the claimant to give 6.6. It then added 15% to represent the complete control of the company that a purchaser would have (unlike a purchaser of shares in a company who would not have control) to give a final multiplier of 7.6. The product of this calculation, £594,320, represented a multiple of 11 on the P/E basis.
The Tribunal also considered the use of alternative methods of assessment such as discounted cash flow (DCF) and the traditional years’ purchase (YP) method. The Tribunal rejected the traditional YP approach due to the lack of market evidence on which it is based.
2.7 Discounting or adjustment of pre-dispossession or post-dispossession losses
Surveyors have generally not discounted future losses back to the valuation date in calculating disturbance losses. Post-dispossession losses or expenditure are usually taken at their nominal cost, but the position is now clear - the compensation should be assessed as the sum necessary to compensate the claimant for all his losses, both pre-dispossession and post-dispossession, as at the valuation date. One question that the Tribunal did not deal with is, if post-dispossession losses must be discounted back to the valuation date, should pre-dispossession losses be projected forward to the valuation date? For example, should a loss that occurred ten years ago, post-scheme but pre-dispossession, be adjusted to account for notional interest over the period up to the valuation date?
3.1 The ‘Crowley and Jarvis’ case
In Crowley and Jarvis v Liverpool PSDA Limited [2007] RVR 125, a case that was heard subsequent to the ‘Optical Express’ case, the Tribunal had regard to evidence of multipliers under both the P/E and YP approaches.
The case involved the acquisition of a business (Contraband Discount Stores) comprising the retail of domestic products at discount prices. The business operated from first and second floor premises above a Kwik Save store in Liverpool. The claimant claimed compensation on a total extinguishment basis and also on the basis that its sister store in Birkenhead had been forced to close as a consequence of the acquisition of the Liverpool store.
The acquiring authority offered compensation only on a relocation basis and was of the opinion that the closure of the sister premises in Birkenhead was not a consequence of the scheme. The claimant and acquiring authority also could not agree on the value of the claimant’s leasehold interest.
The Tribunal determined that an extinguishment basis of compensation was appropriate and that the closure of the Birkenhead store was not a consequence of the scheme. The Tribunal was required to determine, inter alia, the pre-dispossession (pre date of entry) losses incurred by the claimant.
On a total extinguishment basis and disregarding the closure of the Birkenhead store the claimants sought total compensation of £1,296,635 and the acquiring authority offered £329,685. The Tribunal’s determination was £700,000.
3.2 The claimant’s approach
The claimant’s accountant assessed the post-dispossession losses by reference to a net profit after tax multiplied by a P/E multiplier. There was an agreed figure for net maintainable profits before tax of £137,000. He deducted notional owners’ wages, made an allowance for an increase in rent payable from an imminent rent review and deducted tax at 32% to arrive at a net profit after tax of £70,253. He then derived a P/E multiple of 18.9 from an average of four listed companies (Poundstretcher, GUS, Kingfisher and Woolworths) involved in similar types of business. He also had regard to the weighted average for the discount store sector of 12.3 and the average for the retail sector of 16.4 produced by the London Business School Risk Measurement Service.
He took his starting P/E multiplier as 18.9 and from that he deducted an illiquidity discount of 35% (to reflect the unlisted nature of the claimant’s business) to arrive at 12.3. The 35% was derived from a comparison of the P/E ratios of private and public companies using the BDO Private Company Price Index. This showed a 17% reduction in the price of private company P/E ratios compared with public companies but he arrived at 35% having regard to the size and type of business under consideration in the present case. He multiplied the net profit after tax figure of £70,253 by 12.3 and then added a ‘control premium’ of 35% to reflect the level of control and lack of restrictions enjoyed by the claimants compared with running a public or quoted company and arrived at a value of £1,166,512. This included the value of the claimants’ leasehold interest in the property and the assets of the business, which had to be deducted to arrive at a net figure for the disturbance compensation.
3.3 The acquiring authority’s case
The acquiring authority’s accountant took a more traditional approach. Whilst she accepted that the claimant’s P/E method was valid, she thought that the substantial adjustments required in the comparison were so significant as to make the calculation worthless.
She took the agreed figure for net maintainable profits before tax of £137,000, made no deduction for proprietors’ wages (on the basis that this would offend the ‘value to owner’ principle) and applied a YP of 2.6. She derived the YP from an analysis of ten businesses up for sale in the ‘general retail’ and ‘home and garden’ sectors of the website ‘businessesforsale.com’. These showed YP multipliers of between 1 and 4.5 of net profits from which she took an average of 2.6YP. She was of the opinion that the higher YPs were for very successful business operating from freehold premises. Also the YPs related to asking prices that would most likely be reduced in the negotiating process.
This produced a value for the business of £356,200 from which had to be deducted the value of the lease and the assets of the business (stock etc) in order to arrive at the value of the goodwill.
3.4 Tribunal’s decision
The Tribunal accepted as a starting point the agreed figure for average maintainable pre-tax profits of £137,000. It derived assistance from both parties’ approaches. It had regard to the Tribunal’s comments in ‘Optical Express’ regarding the use of the YP approach.
The Tribunal had serious reservations about the YP adopted by the acquiring authority’s accountant and thought that a figure in the range of 4 to 5 YP would be more appropriate. It preferred the claimants’ accountant’s approach in relation to the deduction of proprietors’ wages and making an adjustment for the imminent rent increase. The Tribunal agreed that the large adjustments that had to be made in comparing the claimants’ business with multi-million pound organisations were inappropriate. The claimants’ accountant’s valuation of £1,166,551 represented a16.6 P/E multiple of the net profits after tax figure of £70,253 which was out of all proportion with what the market would expect to pay for a business of this type.
The Tribunal started with the average P/E for the discount store sector of 12.3 and deducted the illiquidity premium of 35% proposed by the claimants’ accountant. This produced a P/E of 8 which applied to the multiplicand of £70,253 gave £562,024. He then added a ‘control premium’ of 20%, which gave a final figure of £674,428. This represented a YP of 4.92 on the acquiring authority’s basis.
The Tribunal ultimately arrived at a valuation of £600,000 after making an adjustment for its own opinion of the FRV of the premises that it had adopted in its valuation of the leasehold interest.
4. General
Notwithstanding the adoption by the Tribunal of a P/E multiplier instead of a traditional YP figure, or of EBITDA instead of the traditional ‘adjusted net profit’ mulplicand, it would still be appropriate to use the ‘traditional approach’ in suitable cases.
The assessment of compensation for a smaller business might not be suitable to be assessed under a more modern approach. For example, in Saglam v Docklands Light Railway Limited [2008] RVR 59 the Tribunal arrived at its determination of compensation for total extinguishment using an adjusted net profit multiplied by a YP. The business comprised a small restaurant serving burger type quick-service foods. The business operated from a lock up shop with basement storage and a small yard area.
5. Adoption of DCF approach
A DCF approach to the assessment of lost profits was first adopted for compulsory purchase in Director of Buildings and Lands v Shun Fung Ironworks Limited [1995] RVR 124 although in that case both parties agreed that the DCF method was appropriate.
In the case of Aslam v South Bedfordshire DC [2000] RVR 121, which concerned a discontinuance order made under section 170 of the Town & Country Planning Act 1971, the future ‘before tax’ net profits of a Hal Al slaughterhouse were assessed on a DCF basis, using a discount rate of 20%. The case was unusual in that future costs of alteration and improvement required by public health legislation were taken into account in the cash flow calculations. The compensation in that case equated to a YP of 3.81 on the ‘traditional’ basis if the future redevelopment proposals were to be ignored.
6. Adoption of ‘robust’ approach
Since the case of W Clibbett v Avon CC [1975 ] 16 RVR 131 the LT has often adopted a ‘robust approach’ to the assessment of compensation for the loss of goodwill. Setting aside the traditional approach (YP x adjusted net profits) because of insufficient evidence to determine on appropriate YP, Sir Douglas Frank in Clibbett adopted an approach used by the courts in assessing general damages and awarded a sum which, in his judgement, was reasonable in the circumstances.
A robust approach in evidence would not be helpful to the Tribunal and an offer of compensation should be built up in detail. Reliance may be placed upon other agreements made by the valuer, or upon the evidenced market value of the goodwill adjusted to establish the ‘value to the claimant’. In most cases this will be done by making an addition to the YP adopted to determine the market value of the goodwill, the addition depending upon the circumstances of the case. In the case of personal goodwill without market value, it will be necessary to look closely at all the circumstances. Such cases certainly warrant use of the robust approach (Roy v Westminster City Council (1975) 31 P&CR 458 but valuers should refer full details of any difficult case to the PS Professional Guidance Team.
7. General
The use of P/E multipliers applied to EBITDA is now established with the Tribunal and may be adopted in appropriate cases. These new methods of assessment of business disturbance tend to produce higher compensation awards compared with the traditional YP method.
The new methods have their failings, the principle one being the number of subjective adjustments necessary to arrive at the appropriate multiplier. This is because the market evidence from which the multipliers are derived tend to be for businesses of significantly different types. To arrive at a P/E multiplier of the EBITDA from an analysis of the market (share) value of multi-million pound companies and then apply it to locally run sole proprietor businesses means that large adjustments must be made which makes the assessment of compensation for disturbance less reliable. Their advantage is that they have a basis in market evidence.
However, it is apparent that in the simpler cases the Tribunal is still prepared to accept valuations on the traditional ‘adjusted net profit x YP’ approach and that this also forms a useful check method when judging the result achieved by one of the more recently introduced valuation approaches.