Valuations for public restaurant companies are very high, and restaurant stocks are in great demand. Recent stock offerings for Good Times Restaurants and Dave & Buster’s underscore that point. In each case, the stock rose during the period the stocks were being marketed, in contrast to the typical decline in price. In this strong environment, owners of private restaurant companies are understandably considering raising outside capital or selling their companies outright. The key question is, what is the company worth?
Most restaurant operators approach valuing their business using a traditional quantifiable methodology that applies a multiple to cash flow. The company is compared with a set of similar public companies that are selling for a certain multiple of earnings or cash flow; that multiple is applied to the company’s earnings or cash flow to calculate its value. In my experience, this relatively simplistic valuation methodology is only relevant to relatively large companies.
There is a continuum between valuing a company using a methodology based on quantifiable measures (science) and one that is based on more qualitative aspects (art) that is overlaid on the size of the enterprise. Art, which includes a degree of subjectivity, is more important in valuing a small company, with the balance shifting to science in valuing a large company.
As an example, a private-equity investor who is interested in providing growth capital to a very small chain with less than 10 units made the point that he does not consider his investment of cash as immediately adding to the enterprise value of the company. His rationale is that cash is going to be spent on new restaurants that may or may not be successful, so there is little true immediate value accretion through his investment. Consequently, based on traditional quantitative metrics that would include the invested cash in determining enterprise value, his valuation of the company is very low. However, he is willing and fully expects to provide the owner with equity incentives based on the performance of the new units. By providing the equity incentives, the investor’s entry-level enterprise value would be adjusted upwards.
There are many other examples of smaller companies that investors have valued at what appear to be levels that are unjustified by the numbers alone. Unlike the above example, the valuations are often higher than what seem to be rational. While art comes into play in these cases, there are certain common quantifiable characteristics that these companies share. These include:
• Overall market position. Any company with “fast casual” attached to its description is assigned a premium valuation in today’s market. While there are some good reasons for interest in this segment, such as low labor and investment costs, that segment runs the risk of becoming overbuilt.
• Unit-level returns. Younger concepts that return the cash investment within three years attract a high level of interest from investors.
• Demonstrated success in more than one market. Strong sales in multiple markets lower the development risk and raise the probability of success regionally or multi-regionally.
• Consistent sales from the early restaurants. Initial restaurants that maintain a high level of sales or show consistent growth demonstrate a lasting appeal of the concept and add to its value.
• Same-store sales growth. This measure also indicates the appeal of the concept, raising investors’ confidence in the brand.
A company that has these five characteristics is more likely to support growth than one that does not have them all. Investors in smaller companies are typically interested in growth, and are willing to pay a premium based on traditional valuation metrics for a small company if they perceive it has the potential to become significantly larger. For both the seller and the buyer, the art is weighting each of these traits and how much to adjust if one or more is absent.
What techniques have you found useful in valuing restaurants? Join the conversation in the comments below.
For example, I am aware of a small company that checks all but one of the boxes above. It is a differentiated concept within fast casual, provides about a one-year cash-on-cash return on investment, and the original unit has grown and maintained a very high absolute sales level in the face of a second location opening, also to strong sales, in the same market. The one element missing is demonstrated success in multiple markets, as the concept is located in one relatively self-contained market. What is value of this concept with store-level cash flow in excess of $1 million? Is it $5 million, $10 million, or some higher or lower amount? Art, not science, will determine that value, and will be heavily influenced by an investor’s weighting of the concept’s quantifiable characteristics.