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RESTAURANT VALUATION: A Financial Approach

The most effective and commonly used approach to determine a restaurant's value is the weighted average capitalization of a restaurant's maintainable cash flow. This article outlines that capitalization methodology and provides restaurateurs the formula to value their operations in an accurate and professional manner

Restaurateurs require valuations of their operations for numerous reasons, including refinancing, unit sales or purchase, or to assess personal net worth. While a professional independent valuation is usually necessary for refinancing, a restaurateur's valuation of his or her own business is usually sufficient for establishing a selling price and assessing his or her personal net worth.

Fair-Market Value

The value of a restaurant should be based on it's fair-market value. Fair-market value is defined as the highest price available in an open market between informed, prudent parties acting at arm's length and under no compulsion to act, and is expressed in monetary terms. This definition works best when the value is based on several restaurants' being available for sale so that the buyer has several purchase options.

Additionally, it is assumed that the restaurant owner is not being forced to sell for any reason. Since the seller is neither compelled to sell nor the buyer to buy, a transaction will take place only if the value of the restaurant is considered fair by both parties.

Financial Evaluation

The valuation procedure outlined here is based on a restaurant's maintainable cash flow. In order to assign a value to this cash flow, the profit-and-loss statements should be formatted according to the Uniform System of Accounts for Restaurants.

Additionally, the cash flow should be adjusted to illustrate actual operating income and expenses only. For example, owner-operated restaurants occasionally pay management (i.e., the owner) a salary in excess of industry norms or fully cover the cost of an automobile that is not used exclusively for business. Such situations allow for greater operating expenses, reduce profit, and, subsequently, reduce tax liabilities. Therefore, each expense should be adjusted in order to reflect the actual operating costs only.

In Exhibit 1, the apparent 1990 cash flow (-O.3%) was adjusted to eliminate the inconsistencies that were created to reduce the associated tax implications.

Additionally, costs that are blatantly out of control, like the actual food costs shown in Exhibit 1, may be adjusted to reflect industry averages for a well-run operation. By incorporating such adjustments, an achievable and maintainable earnings of $71,235, or 11.9 percent, can be projected for the hypothetical operation described in Exhibit 1.

The figure for projected maintainable earnings (i.e., $71,235) will be used in the valuation. Maintainable earnings are defined as the net income that a restaurant can be expected to earn on a long-term basis before depreciation, taxes, and debt service. The restaurateur should state all the assumptions used in arriving at the figure for maintainable earnings (i.e., indicate which items have been adjusted to illustrate the net difference between the actual and projected maintainable cash flows).

Determining the Capitalization Rate

The capitalization rate can be determined in one of two ways.

The first is to determine the equity capitalization rate based on the actual purchase price of similar-size operations. A restaurant would be deemed to be of similar size if the number of seats, target market, gross sales, and net operating profit all correlated with those of the restaurant for sale. The equity capitalization rate can then be determined based on the purchase prices of similar restaurants.

The second method is to determine the weighted average capitalization rate, which establishes a restaurant's value based on its financial position. This latter approach takes into consideration the debt-to-equity positions and principal paybacks associated with the purchase, and the maintainable net operating income of the restaurant.

These two methods are explained in detail below.

Equity capitalization rate.

The equity capitalization rate is based on information related to the actual sales of similar restaurants. Therefore, the restaurateur is required to find similar-size restaurants with comparable gross sales and net operating income that have sold within the past six months in the same community as that of the restaurant being valued.

Once the similar restaurants have been identified, the restaurateur must determine the capitalization rate. First add together the purchase prices of each restaurant sold and divide that number by the number of restaurants used in the sample to obtain an average selling price. For example, if six restaurants were used in the calculation and the total of their purchase prices was $1,140,000, the average purchase price would be $190,000.

Next, perform the same analysis on the net operating income (i.e., the adjusted income before taxes, depreciation, and debt service) of the same six restaurants. If the total operating income of the six restaurants totals $360,000, then the average net operating income is $60,000. The equity capitalization rate in this case would be 31.6 percent, as shown in Exhibit 2.

Weighted average capitalization rate

A more viable method of determining the capitalization rate is by calculating the debt and equity positions that a prudent buyer would take in a purchase situation. This debt-equity split is the "weighted average capitalization rate," and is determined by combining the weighted average of the return required to pay debt service (i.e., the mortgage) with the dividend, or return (i.e., maintainable net income) required by the equity component, which results in a capitalization rate that reflects the basic financial composition of the investment. To determine the debt and equity positions of the investment, the following factors should be considered:

1. It is common practice within the restaurant industry that the financing structure comprises 50 percent equity and 50 percent debt;
2. As a result of the high risk associated with the industry, restaurant investors require a high rate of return. They usually require a payback in approximately three to four years, which equates to a return on equity of 25 percent to 33 percent;
3. Term financing is generally available for restaurants at prime plus two or three points. Banks demand such a high rate of interest due to the risk factors they perceive as being associated with the investment; and
4. A five-year payback of principal is generally required on a restaurant bank loan. Due to the short life of restaurant concepts in general and the fast depreciation of furniture, fixtures, and equipment, the tangible components of a restaurant operation have little residual value after a period of five years.

Given these generally accepted principles, the restaurateur can determine the weighted average capitalization rate by using the following procedure (all figures are cross-referenced to exhibits).

Step 1. The projected maintainable net income is $71,235, as shown in Exhibit 1.
Step 2. The principal loan amount is calculated as follows:

• Estimate a selling price by multiplying the projected maintainable net income (cash flow) by three or four 2 (e.g., $71,235 x 3 $213,705).
• Assume that half of the $213,705 is debt. Therefore, the principal loan amount is $106,853. Round this number to the nearest $5,000 (i.e., $105,000).

Step 3. Develop a principal-and-interest schedule from a standard amortization table, as illustrated in Exhibit 3. Determine the annual principal and interest payments required for a five-year-term debt commitment.
Step 4. The total cost of debt is determined by dividing the combined total principal and interest payments ($142,254, as calculated in Exhibit 4) by the principal loan amount of $105,000. Therefore, the debt percentage return on costs is approximately 35.5 percent ($142,254 ∏ $105,000 = 1.355).
Step 5. Earlier I stated that 50 percent of the purchase price will be financed. Therefore, the weighted cost of debt is calculated by multiplying 35.5 percent (Step 4) by the 50-percent debt position (35.5% x.5 = 17.75%).
Step 6. I also assumed that the other 50 percent of the restaurant's purchase price is composed of an equity investment with a three year recapture period of 33 percent. Therefore, using the same logic as that in Step 5, the weighted equity return on costs is 16.5 percent (33% x.5 = 16.5%).
Step 7. Finally, the weighted average capitalization rate is the Sum of the weighted cost of debt and the weighted equity return on cost, as illustrated in Exhibit 5.

Restaurant Value

Once the maintainable cash flow and capitalization rate are established, simply divide the cash flow by the capitalization rate to calculate the fair-market value of the restaurant, as illustrated in Exhibit 6.
As a result of this valuation procedure, the fair-market value of our hypothetical restaurant is $207,985.

Using the weighted average capitalization rate together with the restaurant's maintainable cash flow is the most accurate method of establishing a restaurant's value. That value is based on the potential earnings of a properly managed business and allows for the required debt and equity returns.

Although other methods of valuation exist, this procedure best combines the business and financial practicalities necessary to determine the actual fair-market value of a restaurant.

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