Legal Framework for Capitalisation of Earnings in Valuation
This article summarises judicial authorities commonly relied upon by valuers when considering whether a capitalisation of earnings approach may be appropriate. The cases discussed are not exhaustive, and the suitability of any valuation methodology depends on the facts of the particular engagement.
Please note that this article is a general summary of valuation principles derived from judicial authorities. It does not constitute advice and is not prepared for the purposes of any particular engagement or dispute.
Introduction
In determining the value of a business or profit-earning undertaking, courts have long recognised that, in appropriate circumstances, value may be assessed by reference to the capitalisation of maintainable profits or earnings. This Appendix summarises the key judicial authorities that establish the legal framework governing when such an approach is considered appropriate, and the cautions that accompany its application.
Pastoral Finance Association Ltd v Minister [1914] AC 1083 (PC)
The decision in Pastoral Finance is frequently cited as an early authority cautioning against the mechanical or uncritical capitalisation of profits. The case establishes that:
Profits must be analysed as to their source;
The valuer must distinguish between profits attributable to:
(I) The land or business itself, and
(II) External, personal, or temporary factors; and
Capitalisation should not be applied in a formulaic manner divorced from the underlying economic reality.
Pastoral Finance therefore stands for the proposition that capitalisation of profits may be appropriate, but only where the profits are maintainable, attributable to the asset being valued, and properly understood.
Shun Fung Ironworks Ltd v Director of Buildings and Lands [1995] 2 AC 111 (PC)
Shun Fung Ironworks is a leading Privy Council authority expressly recognising the legitimacy of capitalising profits in valuation, particularly in compulsory acquisition contexts.
The Board held that market value is not confined to the value of bare land, and that where land is used for an established profit-earning purpose:
“…the value of the land to the owner may be more accurately reflected by capitalising the profits which he could reasonably expect to make from the use of the land.“
The decision confirms that:
- Valuation must reflect economic reality, not artificial assumptions;
- The actual use and earning capacity of the asset may be taken into account;
- Capitalisation of profits is appropriate where:
- (I) The business is established,
- (II) Profits are maintainable, and
- (III) The profits are intrinsically connected to the asset being acquired.
This case provides strong judicial support for the use of an earnings-based valuation methodology where the facts justify it.
Emerald Quarry Industries Pty Ltd v Commissioner of Highways (1979) 142 CLR 351; 43 LGRA 316
In Emerald Quarry Industries, the High Court held that it was appropriate to determine compensation by the capitalisation of profits where the resumption process resulted in a business being extinguished.
Commissioner of Taxation v Murry [1998] HCA 42
In Murry, the High Court of Australia considered the valuation of goodwill and, in doing so, addressed the relationship between earnings and value.
The Court reiterated the caution expressed in Pastoral Finance that one cannot simply capitalise profits without analysis. However, the Court also recognised that:
- The value of goodwill varies with the earning capacity of the business; and
- For a profitable business expected to continue, value may be assessed by reference to the present value of anticipated future earnings, compared with the value of identifiable net assets.
Murry therefore affirms that earnings-based valuation approaches are conceptually sound, provided they are applied with appropriate rigour and are directed to the correct source of value.
Boland v Yates Property Corporation Pty Ltd [1999] HCA 64
In Boland v Yates, the High Court emphasised that valuation is a question of fact and judgment, not a purely mathematical exercise.
While not a profits-capitalisation case in isolation, the decision reinforces that:
- Valuation methodologies must be fit for purpose; and
- Courts will accept valuation techniques that reflect commercial reality, rather than rigid theoretical constructs.
This authority supports the proposition that capitalisation of earnings is permissible where it represents a realistic assessment of value in the circumstances.
Commissioner of State Revenue v Placer Dome Inc [2018] HCA 59
In Placer Dome, the High Court revisited the principles articulated in Murry and confirmed that goodwill is inseparable from the business to which it relates and is inherently connected to earning capacity.
The Court again recognised that:
- The value of goodwill may be assessed by reference to anticipated future earnings; and
- Care must be taken to ensure that earnings-based approaches do not result in double counting of identifiable assets.
This case reinforces the legitimacy of earnings-based valuation, while highlighting the importance of careful analytical separation of value components.
Oakland Freight Terminals Ltd v Ministry of Transportation and Communications (1974) 47 DLR (3d) 400
In Oakland Freight Terminals, the Court referred with approval to valuation principles commonly attributed to Arthur J Little, which outline a structured approach to valuing a business, including:
- Examination of the earnings record;
- Adjustment of earnings to derive future maintainable profits;
- Determination of an appropriate rate of return;
- Capitalisation of adjusted earnings;
- Valuation of tangible and identifiable intangible assets; and
- Calculation of goodwill as the residual.
Queensland and NSW compulsory acquisition authorities
This case is frequently cited in valuation literature as judicial recognition of a methodical, earnings-based valuation framework, consistent with professional valuation practice.
Spencer v Commonwealth (1907) 5 CLR 418
Although an early decision, Spencer v Commonwealth remains the foundational Australian authority on compensation and market value in compulsory acquisition matters. The High Court held that value is to be assessed by reference to what a willing but not anxious buyer would pay to a willing but not anxious seller, having regard to the advantages and potential of the land.
Importantly, the decision recognises that:
- Valuation is not confined to current physical attributes; and
- Economic potential and profitability may be relevant, provided they are not speculative.
This case provides the conceptual foundation upon which later earnings-based valuation approaches have developed.
Nelungaloo Pty Ltd v Commonwealth (1948) 75 CLR 495
In Nelungaloo, the High Court considered compensation for the compulsory acquisition of a pastoral enterprise and addressed the role of profitability in valuation.
The Court referred to Pastoral Finance Association Ltd v Minister and confirmed that:
- Profits may be relevant to value where they reflect the inherent earning capacity of the land or business;
- Care must be taken to ensure profits are not merely personal to the operator or attributable to extraneous factors; and
Earnings evidence must be analysed, not applied mechanically.
Nelungaloo is frequently cited as authority for the proposition that capitalisation of profits is permissible, provided it is grounded in proper analysis and reflects the underlying asset rather than the personal skill of the owner.
Housing Commission of New South Wales v Falconer (1981) 1 NSWLR 547
In Falconer, the New South Wales Court of Appeal reiterated that compensation must reflect the real value of the interest acquired, assessed in a practical and commonsense manner.
While the case did not mandate a particular valuation methodology, it confirmed that:
- Valuation evidence must reflect commercial reality; and
- Courts will accept valuation approaches that rationally explain how economic value is derived.
This approach is consistent with the acceptance of earnings-based methodologies where those earnings are demonstrably maintainable and attributable to the asset.
Melwood Units Pty Ltd v Commissioner of Main Roads [1979] Qd R 36
In Melwood Units, the Queensland Supreme Court acknowledged that compensation assessment is not restricted to a single method and that the Court may consider all relevant evidence bearing upon value.
The decision supports the principle that:
- Valuation methodology is a matter of judgment;
- The appropriate approach depends on the nature of the asset and its use; and
- Where income-producing property or businesses are acquired, earnings evidence may assist in determining value.
Summary of Queensland and NSW position
Taken together, Queensland and NSW compulsory acquisition authorities establish that:
- Market value is to be assessed realistically, not artificially;
- Profitability and earning capacity may be relevant where they inhere in the land or business acquired;
- Capitalisation of earnings is not prohibited, but must be:
- Based on maintainable profits,
- Properly analysed as to source, and
- Applied with care to avoid overstatement or double counting.
These principles align closely with the approach articulated by the Privy Council in Shun Fung Ironworks Ltd v Director of Buildings and Lands and with the High Court’s guidance in Murry.
Conclusion
The authorities summarised above establish that capitalisation of profits or earnings is a recognised and judicially endorsed valuation methodology, provided that:
- Profits are maintainable and properly analysed;
- The source of profits is correctly identified;
- The methodology reflects economic and commercial reality; and
- Appropriate care is taken to avoid mechanical application or double counting.
When applied within this legal framework, capitalisation of earnings is an accepted and robust approach to valuation.
***This article is a general summary of valuation principles derived from judicial authorities. It does not constitute advice and is not prepared for the purposes of any particular engagement or dispute.***
Deferred Tax Liabilities in Business Valuation
Do Deferred Tax Liabilities Reduce Business Value?
Deferred Tax Liabilities (DTLs) and Deferred Tax Assets (DTAs) are common features in company financial statements. However, their treatment in a business valuation particularly in expert reports for litigation, tax disputes, or shareholder matters, often causes confusion and disagreement.
Accounting standards present deferred tax assets and deferred tax liabilities symmetrically.
Valuation practice does not always treat them symmetrically.
This page explains the distinction between accounting recognition and economic valuation, and outlines when deferred tax items should, and should not, affect assessed business value.
Accounting Treatment of Deferred Tax
Deferred tax arises from temporary differences between accounting profit and taxable profit.
- A Deferred Tax Liability generally arises where tax deductions have been accelerated ahead of accounting expense recognition.
- A Deferred Tax Asset generally arises where accounting losses or provisions may provide future tax deductions if sufficient taxable profits arise.
For financial reporting purposes, accounting standards require both DTAs and DTLs to be recognised based on expected future reversal of these timing differences.
However, financial statement presentation is not determinative of valuation treatment.
Valuation Treatment: Economic Reality vs Accounting Form
In a valuation context, the relevant question is not whether an item is recognised in the accounts, but whether it is expected to result in real future cash flows that a hypothetical purchaser would reasonably take into account.
Valuation focuses on:
- Expected future cash inflows and outflows
- Risk and probability of those cash flows arising
- The perspective of a hypothetical willing buyer and seller
Accordingly, deferred tax items should only affect value where they are expected to produce real future cash consequences.
Deferred Tax Assets – Recognition of Future Tax Benefits
A Deferred Tax Asset represents a potential future tax saving arising from carried-forward losses or deductible temporary differences.
In valuation practice, Deferred Tax Assets are only recognised where future taxable profits are reasonably expected, because only then will the tax benefit crystallise as a real cash saving.
Where such future savings are expected, they represent future cash inflows which, when discounted to present value, may contribute to the value of an entity.
Why Accounting Symmetry Does Not Imply Valuation Symmetry
Accounting standards require symmetrical presentation of DTAs and DTLs. Valuation does not.
Valuation applies a consistent economic principle:
- Deferred tax assets are reflected where future tax savings are reasonably expected
- Deferred tax liabilities are reflected where future tax payments are reasonably expected (noting that in many cases the underlying tax deduction has already been claimed, and there is no presently enforceable cash tax obligation arising from the accelerated tax deduction).
This ensures valuation reflects economic substance, rather than accounting form alone.
Conclusion
Deferred tax accounting plays an important role in financial reporting. However, business valuation requires an additional step: assessing whether deferred tax balances will result in real future cash flows relevant to a hypothetical purchaser.
Recognising this distinction ensures valuation conclusions reflect economic reality, not purely accounting convention.
About Rushmore Group
Rushmore Group specialises in forensic accounting, business valuation, and expert valuation reports for commercial, tax, and litigation matters across Australia. Contact us for more information or a confidential discussion.
Valuing a cafe or restaurant
Coffee and visiting a local cafe are part of many Australians’ daily routine. Australians are known for their love of quality coffee and this is reflected by the number of cafe’s across Australia.
At Rushmore Group we provide cafe and restaurant valuation reports for a range of purposes including:
- Purchase or sale of the Business.
- Taxation purposes; and
- Shareholder / partnership disputes.
There is a sizeable market for buying or selling a cafe or restaurants.
Many operators of cafes and restaurants internally measure their weekly takings and in our experience many acquisitions are undertaken on the basis of a multiple of weekly takings (or weekly revenue).
The advantage of the use of a capitalisation of revenue methodology is that the expenses of the Business do not require normalisation. Normalisation adjustments are typically seen with private expenditure, non-operational expenditure, motor vehicle expenditure and the salaries and wages of the Directors of the entity.
Cafe’s and restaurants can also be valued using a more traditional capitalisation of future maintainable earnings (FME) methodology.
More information
We provide cafe and restaurant valuation reports for clients across Australia. If you would like further information in relation to a cafe or restaurant valuation, then please do not hesitate to contact us.
Valuation Best Practices for Business Valuation Firms
The process of undertaking a business valuation should be well understood and free from ambiguity however we find that with many business valuation firms this is not the case.
In a current matter that we are involved in the business valuation firm for the seller of shares in a company treated more than $1 million of shareholder loans by the Company as equivalent to a trade receivable. This caused the value of the goodwill to be misstated. The valuation report also did not include a balance sheet for the entity as at the valuation date. The business valuation firm in question had many years of experience and in our opinion is typical of what we find across a broad range of valuation reports.
At Rushmore Group we are often engaged to either critique or review business valuation reports prepared by others. Where possible we provide our opinion and also any judicial support in relation to the issue in question. The use of case law to support a conclusion can also assist in breaking a deadlock between the parties in a dispute.
Business Valuation Formula
In the above example with the $1 million in shareholder loans ultimately this was an issue with the basic business valuation formula that was used by the business valuer rather than a difference of opinion as to a variable within the formula. Different business valuation experts are entitled to have different opinions as to the appropriate inputs into a business valuation report however ideally the formula and basic methodology should not be in dispute.
We are also still seeing business valuation reports with broad statements. For example, the business valuer will say that in their opinion “a multiple between 3 and 5 is appropriate” and they have then selected the midpoint of 4 times. From the view of preparing an expert report for legal proceedings and indeed any other purpose, we believe that this approach is too broad. It also fails to critically analyse comparable businesses that have been recently sold.
The Business valuer has a number of options available to them in identifying comparable capitalisation multiples. This includes:
- Public announcements as to a purchase and sale of a business
- Independent surveys
- Business for sale advertisements with appropriate adjustments (although this is not as persuasive as transactions that have been completed by a willing buyer and willing seller).
An essential part of the business appraisal service (when applying a capitalisation of future maintainable earnings or discount cash flow technique) is to research and identify comparable transactions. Identifying suitable evidence for an opinion brings a rigor and professionalism to a business valuation report.
Business Appraisal Services
In another matter we are involved with the business valuer in reaching their opinion as to the value of the Business made adjustments that he believed were reasonable. However these adjustments were invalid from a legal point of view. These adjustments made by the valuer changed the business valuation formula and led the business valuer to an erroneous conclusion.
It is therefore important that the valuer has an appreciation for the legal environment that they are operating in.
We typically undertake engagements in relation to the purchase /sale of business, disputes, valuations for tax purposes and restructuring.
At Rushmore Group we specialise in only engagements that include business valuation services. For example undertaking valuations, critiquing valuation reports prepared by others, and related compensation matters with valuation issues. This approach means that we can develop deep expertise in these subject areas.
For a confidential discussion, please contact Rushmore Group today on 1800 454 622.
What You Should Ask Your Business Valuer About Fair Market Value
Business owners often have questions about company valuation issues and one of the questions which often get asked is, “What exactly is fair market value?”
Fair market value of a business can be defined as the monetary value at which the business would exchange ownership between a willing buyer and a willing seller, neither being under compulsion to buy or sell and each having reasonable knowledge of the relevant facts.
In normal business terms fair market value is the value someone like a third party unrelated investor would use to evaluate how much the Business is worth when they have reasonable knowledge about the industry and how the business is run.
Fair market value can be determined by analysing the historical and projected cash flows of the business. Future cash flows are then discounted back to the present value. It also takes into consideration the assets and liabilities as well as the potential growth of the industry or economy.
Other Specific Factors
Any other factors specific to the business are also taken into account. The value could be discounted for:
- Lack of control
- Size of the business; and
- Lack of marketability depending on the situation.
Fair market value is a term business valuation experts use in their reports and refers to the value of a business on the open market.
Here are some reasons, why a business should identify their fair market value.
Change in business structure
Over time a business may need to change its business structure. Determining the fair market value of the Business may be a requirement of the Australian Taxation Office prior to the assets being transferred to another entity.
Disputes and Legal Proceedings
In legal disputes there is often a requirement to obtain an assessment of fair market value. Typically fair market value valuation reports are required in family law/divorce, partnership disputes, shareholder disputes and inheritance disputes.
Long Term Planning
Fair market value is a useful metric which can be applied in the long-term planning of a business. For instance businesses involved with succession planning can transfer shares to a related party or employee. The starting point for succession planning is to find out what the business is currently worth.
After identifying a successor the next step is to find out the buy-out value of the business. Parents looking for children to take over the business may be relying on the family business to fund their retirement.
The children may have different ideas about where they want to take the business. A succession plan helps align the family interest and avoids conflict.
The valuation of a business can change substantially in relatively short periods of time. Working out the fair market value helps in making appropriate long-term plans relating to transfers, divisions, and consolidations.
Are you looking for a professional business valuation provider to help you identify the fair market value of your business? One of Australia’s top business valuation firms, Rushmore Group is renowned for providing business appraisal services for more than 10 years and offers assistance for both large and small business valuations. If you’re looking to get a business valued please call us on (1800) 454 622 today for more details.
4 Important Qualities of a Trusted Business Valuer
Handling and managing a business is definitely not a walk in the park. You always need to be alert and prepared to address any issue that may arise. After a few years of operating the business, are you wondering how much it costs now? Do you want to know how far you have achieved after all those months? In that case you should seek business appraisal assistance.
Availing of a business valuation service is pretty straightforward and easy these days, thanks to the internet.
However, you should not pick just any business valuer to do your bidding. You have to make sure that he or she is good and trustworthy enough to conduct a professional business valuation. Here are four qualities you should look for in a business valuer:
- Experience – Before working with anyone, make sure he or she has enough experience in using a business valuation formula. Check his background and work history to know more about whom you are working with.
- Affiliation – One way you can check a professional’s track record is by finding the different groups and associations where he is connected. Usually, these groups will have an entire roster of their membership so you can check.
- Reputation – What do people say about the firm or specialist? Are they satisfied with the service, or did the ‘expert’ make a mistake? You have to know how good your business valuer would be.
- Rates – Finally, you should check the rates of the firm or individual. In order to make a more informed decision, check 3 or 4 business valuation firms and get the average of their professional fees.
As you may have observed, rates and fees for business valuation should not be the first consideration. If the rate is too low, then the service provider is probably not that good. Availing of the lowest rate may lead to mistakes, which means inaccurate and unprofitable results for your business.
In case you are looking for a top-notch valuer, one of the top business valuation firms in Australia is the Rushmore Group. Established in 2006, the Rushmore Group has been using effective business valuation methods over the years, to the delight of its clients. To know more about this firm, just dial (1800) 454 622 or fill out this form.
Earnings Multiple Valuation
Earnings Multiple Valuations are suitable for a range of entities that are consistently profitable.
In most business valuations that we undertake we use an EBIT multiple on which to capitalise the future maintainable earnings. In some cases we will use an EBITDA multiple to capitalise maintainable EBITDA.
An earnings multiple valuation is generally not appropriate where:
- The business or entity has made losses.
- The business is of a type where it may be appropriate to value the business using a different technique (e.g. a financial planning practice on a multiple(s) of recurring revenue or a restaurant on a capitalisation of weekly turnover).
However its important to note that every business valuation engagement is different and there may be an exception to the above guidelines.
An earnings multiple valuation is considered a proxy for a discounted cash flow / net present value valuation. A net present value valuation is considered the most academically sound valuation (albeit there are a number of challenges to using the technique particularly with small to medium enterprises).
If you would like further information about the use of an earnings multiple valuation or a business valuation in general, then we would be delighted to speak with you further.
Rushmore are specialist small to medium market business valuers. We offer a fixed fee service of $4,990 per valuation plus GST and our reports are suitable to be used for taxation, buying a business, selling a business, restructuring, shareholder / partnership disputes and other purposes. Please contact us for more information.