Valuation evidence
130 Mr Carter is a chartered accountant with 25 years experience in share and business valuations over a wide range of large and small businesses. He has not previously undertaken a valuation of a service station business, but I accept his evidence that there is no difference in principle between valuing a service station business and any other business. In Mr Carter's opinion there are two broad circumstances in which one would conclude from an examination of a businesses' financial performance that the business has no valuable goodwill. The first is where the business is incurring losses and where there is no indication that those losses will cease, ie past losses look likely to continue. The second is where the business is deriving profits, but where those profits represent a rate of return which is less than a reasonable rate of return for the capital required to be invested in the business. The long term government bond rate, currently about 5˝ per cent per annum is the absolute minimum rate of return required, as that represents the 'risk free' rate. The rate of return which Mr Carter adopted for the purposes of his report was 20 per cent.
131 Mathematically the value of goodwill is calculated by accountants as the difference between the value of the business and the net tangible (and specific identifiable intangible) assets of that business. It follows from an accounting viewpoint, that where a business will be unprofitable for the foreseeable future, it is likely that no goodwill exists, since the value of the business will likely be calculated as the value of the net tangible assets.
132 Mr Carter is not qualified to conduct valuations of land, and he does not undertake land valuations. Charles Verheyden is an expert in the field of real estate valuation who was retained by the applicants to establish in relation to each service station site a fair market value for the property and business pursuant to the criteria as set out in the instructions set out in the applicants' solicitors letter of 26 May 2003. Mr Verheyden has been a valuer of commercial real estate for about 30 years, and in that time has valued approximately 35 service stations. The letters of instruction included the following:
'Clause 2.5 states that the valuer in making the determination (as to market value) shall have regard to all factors the valuer considers relevant but shall not include in the determination of the market valuation of the Property any allowance for any goodwill attaching to any business conducted at the property.
As you will see goodwill is to be excluded however the definition dealing with determination of price requires a market valuation of the property as an operational service station. It appears that one provision contradicts the other. However, I ask that you provide a valuation of the site as an operational service station and exclude goodwill. As I see it the business will need to be valued as part of the operational service station. Such things as sales of fuel, mechanical workshop, car wash, sales from shop etc will need to be taken into consideration.'
133 Each of the valuations prepared by Mr Verheyden contained the following comment:
'2. The fact that the subsequent Clause 2.5 contradicts the primary instruction in sofar as the "operational service station" value for all intents and purposes is a "going concern" - which invariably contains a component of goodwill - as usually included with balance sheet - 2.5 requires the goodwill component to be excluded would be comparable to deliberately excluding a component from the CPI so as to manipulate its effect.'
134 Each of the valuations prepared by Mr Verheyden contained the following observation:
'Goodwill is normally defined as the benefits which accrue to a business as a result of location, exposure, management, skill, type of product and/or service, potential and any other criteria which may contribute to the retention of existing and the acquisition of new clientele. It is a well known fact that a ready, willing and capable but prudent entrepreneur gives preference to taking over an existing business with apparent potential rather than to start from scratch and run the risk of becoming a statistic with record of failures which is well in excess of 50% in the first few years of trading.'
In cross-examination Mr Verheyden accepted that the value which one attaches to goodwill is determined by reference to the profits which accrue to the business by reason of the matters identified in the quoted passage. If a business is generally unprofitable, the value of the business is unlikely to be greater than the value of its tangible assets.
135 It is clear from Mr Verheyden's reports, and from his evidence, that he construed his instructions as requiring that matters such as improvements, location and the potential of the service station sites to earn profits be treated as contributing towards the goodwill of the businesses conducted at those sites, rather than as matters to be taken into account in the valuation of the real estate. However, Mr Verheyden agreed in cross-examination that the value of any improvements erected on the sites, the location of the sites and the potential to earn profits from the exploitation of the sites are all factors of which account is to be taken in the valuation of the site as an operational service station. That is not the approach taken in his reports.
136 In relation to BP Lansvale, Mr Verheyden expressed the following opinions:
- the value of the goodwill of the service station business when it was acquired by Ringrow in May 1999 was $550,000. Alcorn Corbin Nicholson's valuation of 23 February 1999 valued BP Lansvale on a going concern basis at $850,000 and on a non-petroleum use basis of $650,000. The difference between these figures ($200,000) represents the value of goodwill. Ringrow paid $1.2 million to acquire the property which, by implication, indicates a goodwill component of $550,000.
- Ringrow effected improvements to the property post acquisition at a cost of $764,450, with the result that turnover has increased over 1999 levels by 37 per cent in the case of fuel sales, and 40 per cent in the case of shop sales. It is therefore reasonable to conclude that goodwill has increased by 40 per cent (or $220,000) to $770,000.
- The value of the service station and improvements was assessed as at 13 September 2002 by David Nelson at $2,100,000 based on a 10 per cent capitalisation rates.
- The current market value of the service station as a going concern is $2.87 million ($2.1 million + $770,000).
- The increase in the value as an operational service station due to the improvement in sales (all categories) made to the site since the date of purchase on this basis the value of the site is the summation of:
Asset value $2,100,000 - $650,000 = $1,450,000
Goodwill $ 770,000 - $550,000 = 220,000
Total increase $1.670,000
137 In relation to BP Auburn, Mr Verheyden expressed the following opinions:
- The Alcorn Corbin Nicholson report valued the service station at $1 million both on a going concern basis and as a redevelopment site. 'No allowance is made for goodwill'. Ultimate Fuel paid $1.4 million to acquire the site which, by implication, indicates a goodwill component of $400,000.
- Some improvements to the site were made by Ultimate Fuel. Turnover has increased from 1999 levels by 145 per cent (fuel sales) and shop sales are expected to increase by 300 per cent between 1999 and 2003. It is therefore reasonable to conclude that goodwill has increased by 2.5 - 3 times the value of goodwill as at the time of acquisition, ie between $1 million and $1.2 million; say $1.1 million.
- The balance sheet value of land and buildings at 30 June 2001 was $1,468,090. Market appreciation between then and 30 June 2003 is 10 per cent per annum, and improvements were effected in that period at a cost of $136,000 giving a value of $1.9 million as an operational service station at 30 June 2003.
- The current market value of the service station as a going concern is $3 million, ie the summation of:
Asset value $1.9 million
Goodwill $1.1 million
Total $3.0 million
138 In relation to BP Silverwater, Mr Verheyden expressed the following opinions:
- The valuation carried out by Alcorn Corbin Nicholson Pty Ltd as at 1 June 1999 valued the property at $1 million as a redevelopment site, and $800,000 on a going concern basis. Nader-One paid $780,000 to acquire the site. No allowance for goodwill is implicit in these figures.
- Some improvements were made to the site by Nader-One. Turnover has increased since 1999 levels. It is therefore considered reasonable to conclude 'that goodwill has been generated due to the improvements carried out particularly with an increase of fuel capacity based on a conservative net profit as per David Nelson Pty Ltd analysis a net profit of $196,364 was recorded after add backs. It is reasonable to expect this performance to be sustained. A goodwill amount of two years net before tax has been adopted as a direct result of the increased capacity created by the added improvements. Say $400,000'.
- David Nelson assessed the site value as at 31 October 2001 at $1.6 million as a going concern. The market appreciation in this precinct has been approximately 10 per cent per annum which, compounded indicates a value of $1.9 million on $2,111,000 (if account is taken of improvements) on a going concern basis. That sum is comprised of:
Asset value $1,711,000 ($2,111,000 - 400,000)
Goodwill 400,000
$2,111,000
139 The following general points should be made in relation to Mr Verheyden's evidence:
- he has not valued any of the service station sites himself. He has assumed the correctness of valuations by Alcorn Corbin Nicholson Pty Ltd (which are in evidence) and by David Nelson Pty Ltd (which are not in evidence);
- in the case of BP Lansvale and BP Auburn, the proposition that valuable goodwill existed in relation to the businesses conducted at these sites at the point of acquisition derived from the assumption that if an applicant was prepared to pay more than a valuation of the site, then the explanation for the difference must be an allowance for goodwill. There is nothing to suggest that the applicant was aware of BP's valuation. In cross-examination Mr Verheyden accepted that 'it could be the case' that the fact that somebody may be prepared to pay a particular price for a particular business for one reason or another does not of itself suggest that there is any value attaching to what is properly called goodwill;
- 'lifestyle factors' are erroneously included by Mr Verheyden in the notion of goodwill. Mr Carter's evidence (which I accept) is that the lifestyle benefits referred to by Mr Verheyden are not goodwill because they have no bearing upon the ability of the business to attract custom;
- whilst he agreed in cross-examination that the existence of valuable goodwill is related to maintainable profits, except in relation to BP Silverwater, he deduced an increase in the value of goodwill from increases in turnover. Mr Verheyden accepted in cross-examination that an increase in turnover did not necessarily result in an increase in profit, as for example, where sales volume is increased, but margins are reduced.
140 Mr Carter made an assessment of the value of the service station businesses on the assumption that the trading statements and profit and loss statements earlier referred to are reliable (an assumption which he does not regard as correct) and on the assumption that no further financial information is available. He made an estimate of the future maintainable earnings for each service station business. Adopting a multiple of 5 (which is equivalent to a rate of return of 20 per cent), the resulting value of each business is as set out in the following table. There is also shown the asset value adopted by Mr Verheyden.
High Low Midpoint Verheyden
$000 $000 $000 $000
Lansvale 1,375 1,125 1,250 2,100
Auburn 500 250 375 1,900
Silverwater 250 0 125 1,700
141 The value of each business as determined by Mr Carter is significantly below the asset values adopted by Mr Verheyden. Since the asset value in each case exceeds the value of the business, then it follows that no valuable goodwill exists for these service stations.
142 Mr Carter did not have access to the applicants' tax returns when he prepared his report. The report was based upon figures more favourable to the applicants than those contained in the tax returns. Mr Carter's evidence is that the opinions which he expressed in his report are reinforced by the material in the tax returns.
143 Mr Carter makes the following general criticisms of Mr Verheyden's reports:
- Mr Verheyden fails to examine the actual relevant financial data of the businesses.
- The financial statements provided to Mr Carter (and apparently to Mr Verheyden) contain obvious errors and are not of a standard that could be relied upon for the purpose of a valuation of those businesses.
- Mr Verheyden assumes that goodwill increases proportionately to growth in turnover, without consideration of the profitability of the business. This approach is invalid. For example, it is reasonable to expect that a service station which offered fuel at an unprofitably low price, below the price of its competitors, would be likely to increase its turnover dramatically in a busy location. However, this would not improve the value of the goodwill of the business. It may have the opposite effect.
- Mr Verheyden does not consider whether the values he derives for the service stations may be justified by reference to a reasonable rate of return on investment. In Mr Carter's opinion, the valuations reached by Mr Verheyden are not consistent with business profitability and reasonably expected rates of return on investment.
- Mr Verheyden fails to consider whether the valuations he has prepared are consistent with each other. BP Auburn recorded the worst result in 2002 (a small loss), but has the highest level of goodwill. Goodwill in BP Lansvale is assessed at 3.1 times the 2002 profit (excluding interest), but in the valuation of BP Silverwater goodwill is assessed at 2 times the profit. In valuing BP Auburn, no such comparison is made.
- It is unreasonable to assume that the difference between the original purchase price paid by an applicant to acquire a service station, and the value placed on the service station by BP's valuer, is goodwill. For example, the difference might be explained by:
· an error in the valuation by BP's valuer;
· advantageous negotiating skills on the part of BP's valuer at the time of sale;
· a belief by the purchaser that the property was worth more than BP's valuer had assessed it to be;
· poor bargaining by the purchaser; and
· changes in circumstances between the date of the valuation and the time at which the transaction occurred.
144 These criticisms are soundly based. They demonstrate that it is unsafe to rely upon Mr Verheyden's conclusions as to the existence of valuable goodwill in relation to BP Lansvale and BP Auburn. Whilst the methodology adopted for BP Silverwater is different, the figure of $400,000 for goodwill is based upon two years profits. The tax return for Nader-One for 30 June 2002 records a loss of $24,463, which, when interest is added back, results in a profit of the order of $10,000 which suggests a figure for goodwill in the order of $20,000.
145 Mr Carter's calculations of the value of the businesses are based on the same flawed financial statements. However, the conclusions which Mr Carter drew from those statements that no valuable goodwill exists for these service stations is reinforced by the figures contained in the tax returns, which Mr Nader and Mr Ayoub accept are more reliable. The conclusions are also consistent with the evidence of Mr Nader and Mr Ayoub as to the importance of matching or beating the board prices posted by competitors if volume is to be maintained, and with their evidence that once the retail price of petrol exceeds the competitors' price from as low as 0.5 cents/litre (Mr Nader) and 0.2 cents per litre (Mr Ayoub), sales of petrol start to decline.
146 For these reasons I prefer the opinion expressed by Mr Carter to that expressed by Mr Verheyden. It follows that the applicants have failed to establish the existence of valuable goodwill in relation to any of the service station sites of which an applicant will be deprived without adequate compensation by virtue of the exercise of the options. Mr Carter makes a number of more detailed criticisms of Mr Verheyden's reports in relation to matters such as double counting etc. These were not the subject of specific submission by either counsel, and it is unnecessary for me to deal with them.