The Truth About Blue Sky
It goes by the name of business value, intangible assets and blue sky. It is that portion of the value of a business that is over and above the worth of the tangible assets.
Among real estate appraisal practitioners, it is hotly debated as to whether business value even exists. The naysayers insist that any extra economic value accrues to the land.
Within the convenience store industry, however, the concept of business value is commonly accepted and frequently allocated as part of the transaction price in a sale of a convenience store. In this column, I will explore the economics of business value for the average convenience store. Does every c-store operation have business value? If so, what is it worth? Can a buyer pay too much for business value?
Business value exists in the convenience industry for at least three reasons:
1. Market participants (buyers and sellers) believe business value exists. Sellers often demand compensation for business value and buyers pay for it.
2. The ability to earn a profit is the motivation for owning a business. Economists recognize the profit incentive in a free market.
3. The convenience industry publishes the industry-average “pretax profit per store." According to the annual Convenience Store News Industry Report, this figure was $44,511 in 2011. Pretax profit is similar in concept to “accounting profit,” which is a recognized component of business value.
Business value accrues from excess earnings, those over and above the economic return to the tangible assets. Profit is never guaranteed. A hypermarket could be built across the street tomorrow that wipes out the profit a store had the previous year.
The chart below illustrates how higher earnings increase the value of a going concern. Beginning at the bottom, the earnings from the business must satisfy the economic requirements of each of the five successive layers before any profit exists. In other words, earnings must be high enough to pay the economic requirement of one layer before proceeding to the next. Layers 6 and 7 are the components of intangible asset value, or blue sky.
Because of the risk of receiving any profit greater, the market discounts the value of pretax profit. Current returns on this portion of a store’s earnings are about 30 percent to 50 percent. So, the average convenience store business in the United States today has a business value of about $89,000 to $148,000 ($44,511 divided by 30 percent to 50 percent).
Due to federal tax law, sometimes we see sellers or accountants mistakenly allocate 30 percent or so of the total sale price to the business value. On a $1 million sale, for example, this would be $333,000, far above the industry average economic value of $89,000 to $148,000. Most stores, in reality, cannot support this high number. This high allocation overstates the business value and understates the value of the real estate.
Robert E. Bainbridge is an author, instructor and expert witness in the appraisal and valuation of convenience stores and gas stations. He can be reached at [email protected] or (541) 823-0029. Find more valuation information at www.cstorevalue.com.
Editor's note: The opinions expressed in this column are the author's and do not necessarily reflect the views of Convenience Store News.