Valuation Guide: Restaurants

Description of the Industry

The restaurant industry (SIC 5812, NAICS 722110) consists of table-service dining establishments.  These establishments may also engage in the sale of alcoholic beverages, takeout services, and entertainment.  In general, full service restaurants differ from fast-food or other dining places in that they (i) have a full menu of appetizers, entrees, desserts, and beverages, (ii) cook food to order, and (iii) serve and wait on seated customers.  Approximately 39 percent of restaurants are casual dining restaurants, followed by Asian restaurants (20 percent), and traditional American restaurants (12 percent).[1]

The U.S. restaurant industry generates approximately $149 billion a year and employs more than 4.5 million people.[2]  Approximately $55 billion,[3] or 37%, of industry revenue comes from chain restaurants, with the remaining $94 billion[4] (63%) coming from single location restaurants. The industry remained fairly stable over the past five years, with single location restaurants experiencing annual growth of 0.6 percent[4] and chain restaurants showing a decline at –0.1 percent[3] growth. The industry is expected to see an increase in sales in the coming years, as the economy recovers and customers have more disposable income to spend on eating out.[4]  Americans typically spend just under half of their food expenditures in restaurants.[5]

The U.S. restaurant industry has reached the mature stage in its lifecycle.  Within the U.S., most markets have reached the point of saturation.[6]  Restaurants compete intensely for high profile locations, and price-based competition is increasingly common.[6]  Due to the highly saturated domestic market, any future expansion will most likely occur abroad, particularly in China.[6]

Full service restaurants include national chains, regional chains, franchises, and independent operators.  Some of the biggest players in the restaurant industry, both private and public, include:[7]

1. Cheesecake Factory
2. Denny’s
3. Applebee’s
4. Outback Steakhouse
5. Benihana
6. T.G.I Friday’s
7. P.F. Chang’s China Bistro
8. California Pizza Kitchen

Industry Trends

Trends in the restaurant industry have changed over the past several years, especially in response to shifting consumer preferences. A few of the most significant changes are:

1. More restaurants are using organic and/or locally sourced produce.
   As more Americans are becoming environmentally aware and health conscious, more restaurants are using organic and locally sourced produce in their dishes. According to the National Restaurant Association, more than 70 percent of consumers say they are more likely to visit restaurants that offer locally produced items, and more than 60 percent considered named locally sourced menu options as a key factor when choosing a restaurant.[8]  Organic and locally produced food is generally more expensive than the alternative and is most prevalent in fine dining establishments.
2. Bite-size/mini desserts are gaining popularity.
   Both chain and fine dining restaurants have embraced the bite-size desserts trend.  Their small size and price compared to larger desserts is appealing to customers who have just eaten a large meal and want something small and affordable for dessert. Small and affordable treats can also help increase sales in other categories, such as coffee or wine to accompany dessert.
3. Restaurants depend on positive reviews.
   Online restaurant review websites, in particular Yelp, have become increasingly popular.  45 percent of adults say that they use online dining guides to decide whether or not to visit a new restaurant.[9]  Negative reviews can damage a restaurant’s reputation while positive reviews boost popularity.  One report found that a one star Yelp rating increase corresponds with a 5 to 9 percent increase in revenue for independent restaurants.[10]  Chain restaurants, on the other hand, do not experience any significant increase as a result of reviews.  In fact, as the percentage of restaurants reviewed on Yelp and similar websites increases, chain restaurants stand to lose up to 5 percent of sales.[11]

Key Fast Food Performance Metrics

The following are performance metrics that managers in the restaurant industry use to benchmark their performance against others in the industry:

1. Hourly sales per restaurant
2. Orders and sales
3. Ticket dollar average
4. Cash Flow
5. Payment mix (cash vs. credit card)
6. Percentage of repeat customers
7. Table-turn
8. Tip percentages

Summary of Valuation Approaches

There are four different types of valuation methods that can be used to value restaurants, as follows:

1. Asset-based valuation: This method calculates a business’s equity value as the fair market value of a company’s assets less the fair market value of its liabilities.  This approach is also sometimes referred to as a “cost based approach”; that is, the business value is equal to the cost of acquiring its physical assets.

2. Income approach to value (capitalization of earnings): This method is most applicable to franchises that face predictable and constant growth in earnings and have a long history of operations.  The business value under this method is equal to the cash flow projection for one year divided by a capitalization rate (i.e. the appropriate discount rate less the predicted growth rate). This method is most the accurate for restaurants, which usually have a constant growth of earnings. The capitalization rates for restaurants range from anywhere from 20% up to 100%.

3. Income approach to value (discounted cash flow): The value of equity utilizing this method is equal to the present value of free cash flows available to equity holders over the life of the business. This method works well for both established companies with low growth rates as well as new companies with higher rates of growth, but requires predicting changes in future cash flows.

4. Market approach to value: This method utilizes market indications of value based on metrics from guideline publicly traded fast food companies and privately held companies.  The financial metrics of public companies or those of private transactions can be used to create valuation multiples that are then used to calculate business value.

Benchmark Statistics

The following benchmarking data is based on studies from various companies within the restaurant industry: [12]

	2007	2008	2009	2010	2011
Gross Profit (% of Net Sales)	60.1%	60.3%	61.3%	60.9%	60.3%
Operating Profit (% of Net Sales)	4.1%	3.3%	3.8%	4.0%	4.1%
Sales/Working Capital	-49.6	-45.2	-51.2	-60.6	-67.4
% Owners Compensation/Sales	4.2	3.8	4.0	3.7	3.8
Cost of Sales/Inventory	36.8	36.4	35.1	35.6	37.6
Debt/Worth Ratio	5.7	6.3	6.1	5.4	5.5
Current Ratio	0.7	0.7	0.7	0.7	0.8
Quick Ratio	0.4	0.4	0.4	0.4	0.4

Before using this data for specific valuation purposes it should be evaluated for appropriateness.

Industry Organizations and Publications

Some organizations that publish helpful information about restaurants include:

1. National Restaurant Association: www.restaurant.org, an association representing more than 380,000 businesses involved in the restaurant industry[13]
2. Restaurant News Resource: www.restaurantnewsresource.com, a source of restaurant industry news
3. Nation’s Restaurant News: www.nrn.com, news source for the restaurant and food service industry

Availability of Publicly Traded Comparable Companies

There are approximately 37 publicly traded companies in the U.S. restaurant industry. [14] The top five publicly traded restaurant companies, ranked by market capitalization, are:[15]

1. Darden Restaurants Inc. ($5.9 billion)
2. Brinker International Inc. ($2.3 billion)
3. The Cheesecake Factory Inc. ($1.8 billion)
4. Buffalo Wild Wings ($1.4 billion)
5. Texas Roadhouse Inc. ($1.2 billion)

The price to earnings ratios of these companies range from 12.3 to 24.9.13  As a whole, publicly traded companies in the restaurant industry have a price to earnings ratio of 21.4.[16]

Availability of Private Purchase Transactions

In addition to public restaurant companies, data regarding privately held companies can also provide a useful benchmark when valuing a restaurant business.  The size and scope of private companies that have been bought and sold over the last five years varies greatly, both in terms of their sales and the purchase price paid for the companies.

Fulcrum identified 544 private purchases of restaurant businesses over the five year period from July 1, 2007 through June 30, 2012.  These transactions show the following ranges:[17]

1. Total deal values ranged from $5,000 to $92 million.

2. Market value of invested capital (MVIC) to net sales ranged from 0.03 to 2.14 times with a median of 0.30.

3. MVIC to earnings before interest, taxes and depreciation (EBITDA) ranged from 0.11 to 256.55 times with a median of 1.78.

This range of market multiples is too variant to be useful without further analysis. As with selecting publicly traded guideline companies, care should be given to select private transactions that share similarities with the subject company.  The financial metrics of a potential guideline transaction should be compared with those of the subject. Additionally, industry economic conditions also vary over time, which can affect restaurants as investment opportunities.  Specific factors that are unique for each company must be considered.

Fulcrum Inquiry performs business appraisals for restaurants and other businesses.