Business Valuation

Business Valuation: Restaurant Valuation Issues
August 10th, 2010 10:36 AM

Consumers have a myriad of options concerning where to spend their food money: fast food, fine dining, fast casual, delivery, take-out, drive-thru, sit-down, and then there is the grocery store. You name it, and it is probably available to most Americans. Needless to say, the restaurant industry can be a tough place to build and maintain value. Fortunately for business appraisers, despite the uniquely competitive nature of restaurants, their values are dependent on the same value fundamentals as all businesses: the timing and magnitude of expected future cash flows and the perceived risk associated with those cash flows.

EARNINGS
The greater the cash flows to equity (or earnings as a normalized measure of cash flow) of a business, the greater its value to shareholders, as this cash can either be distributed or reinvested. Some specific earnings-related value drivers at which we might look when valuing restaurants are:

·  Quality of food, service, atmosphere, and cleanliness—these items affect the customer’s perceived value and create the ability to charge higher prices, increase units sold, or both. The ability to consistently produce a high quality customer experience can generate customer loyalty, a sustainable competitive advantage, and attractive profit margins.

·  Location, visibility, and convenience—a quality, easily accessible location can increase sales, which is particularly important for restaurants where convenience is a key part of value to the customer, such as fast food restaurants. The quality of the location can be measured through traffic counts, but factors such as visibility, traffic patterns, and ease of entry might also play a role.

·  For restaurants that serve alcoholic beverages, liquor sales—because these are typically very high-margin items, liquor sales are an important part of profitability.

·  Equipment choices—the appropriate equipment maximizes efficiency. Excess equipment can tie up capital and reduce returns on assets, while inadequate equipment can reduce capacity, increase service times, or increase labor costs.

While we review financial statement earnings measures when appraising restaurants, we often also assess industry-specific measures, if available. These measures focus on assessing the restaurant’s performance relative to its three main costs: food, labor, and facilities:

·  Food loss rates, gross profit, and similar metrics measure the restaurant’s use of raw materials.

·  Sales per labor hour, sales per labor dollar, and similar metrics measure the effectiveness of management’s labor use.

·  Sales per square foot or sales per chair measure the effectiveness of the fixed cost of the restaurant location.

By looking at industry-specific measures, we can evaluate the performance of the subject business in the context of its peers.

GROWTH
The growth prospects of a business are important in driving value. An investor will pay more for a restaurant that is expected to generate a growing cash flow stream, because these cash flows can be distributed or reinvested in the business. For restaurants, growth may require additional locations or new types of operations. Some of the growth- related value drivers we might examine when valuing a restaurant or chain of restaurants are:

·  Easily expandable, well-documented restaurant concepts and operations—even restaurants with highly-desired secret recipes or exceptionally well-run operations can fail at growing past a single location when the “secret sauce” is all in the owner or key manager’s mind. Restaurants that have designed their concept for ease of expansion and have documented all of the necessary operational procedures to ensure that the same standard of quality is met at each new location will generally be perceived as having more attractive growth prospects.

·  Ability to select appropriate locations—restaurants that have a developed and successful process for selecting sites for expansion will have greater growth prospects. As is the case with any retail business, the appropriate balance of location, traffic, convenience, and cost is key. One way we might assess a restaurant’s ability to select locations is to examine the sales per square foot or sales per chair of its current locations.

RISK
A more certain cash flow of a given expected magnitude and timing will be more valuable than one that has less certainty. This is why higher interest rates are charged on riskier loans, and it is why investments that are perceived as safer tend to be more valuable than those that are perceived as precarious. When valuing restaurants, risk factors we might examine include:

·  Strategic positioning of the restaurant—having a clear, maintainable competitive advantage gives hypothetical buyers increased confidence in the earnings and growth of the restaurants.

·  Strong food and health safety practices—enhance the customer experience and reduce the potential for lawsuits.

·  Consistency of food and service quality—increase confidence in earnings and growth.

·  Financial leverage—the use of less debt decreases the perceived risk of equity holders by decreasing the chance of bankruptcy.

·  Operational leverage—the lower the percentage of fixed costs (such as rent) as a portion of total costs, the lower the restaurant’s perceived earnings risk.

EXTERNAL FACTORS
In addition to the above value drivers that restaurant owners and managers can control, the following are a few factors that are outside of the owner or manager’s control:

·  Consumer trends—a newer, “trendier” restaurant’s concept may be perceived as more risky. Consumer tastes can change; however, a proven restaurant concept with a loyal following is less risky. Trends can also provide growth opportunities. For example, fast casual concepts such as Panera Bread and Starbucks have experienced significant growth during the past decade relative to the industry as a whole.

·  Local economy and population growth—a healthy local economy can lead to greater amounts spent on food away from home. Strong population growth can increase the potential customer base while it decreases the cost of and increases the accessibility of labor. These items can increase earnings and growth, as well as possibly reduce risk.

·  Degree of competition—heavy competition inside and outside of the restaurant’s niche can lead to price competition. This can reduce sales and earnings, lessen growth prospects, and increase the perceived risk of the restaurant’s cash flows.

Decosimo Advisory Services professionals have the benefit of more than 30 years’ experience in valuing, advising on buying and selling, financing, and providing consulting services to a wide range of restaurants, chains, and franchises—both large and small. If you would like to discuss the value of your restaurant or how Decosimo might help you to maximize your establishment’s value, call us in confidence at 800.782.8382.

Mike Costello  |  mikecostello@decosimo.com
Andrew Gardner  |  andrewgardner@decosimo.com

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