Strengths and Weaknesses of Rule of Thumb Valuations for Restaurants/Bars
Introduction
We’ve been asked before, “Why do I need to have my business appraised? We’ll just price it using an industry rule of thumb.”
In some instances, with an experienced operator, that may be all one needs. However, consider the phrase “rule of thumb”, and whose thumb is being used to do the actual measuring. Are you going to use Verne Troyer’s thumb, or Andre the Giant’s?
There are literally thousands of rule of thumb calculations for determining the value of a small business. Most industries have more than one rule of thumb, depending on whom you ask, and they generally provide a range of potential value indications.
This post goes over two widely used rules of thumbs for restaurants, and points out their strengths and weaknesses.
Rule of Thumb Example #1: One Times Total Revenue
The first rule of thumb is one times total revenue, abbreviated as:
1x Gross Revenue
Looking at this rule of thumb, one times total revenue, it seems pretty straight forward. However, with greater scrutiny, there are several additional factors that this does not necessarily take into account.
Take, for example, a restaurant that did $750,000 in annual sales last year. We’ll call this “Restaurant A”. The back story to Restaurant A is that the restaurant is performing worse than the industry average and it does not own any of the furniture, fixtures and equipment (FF&E). The restaurant had $750,000 in annual sales last year but the year prior annual sales were $1,400,000. The lease is coming due in a year and the landlord is unwilling to allow them to occupy the space unless they pay 30% more.
On the other hand, Restaurant B had $750,000 in annual sales last year which was higher than the industry average. It owns all FF&E free and clear, annual sales were up from $500,000 the year prior, it has an excellent location with a good lease rate and 10 years remaining on the term, in an area of town poised for growth.
According to this rule of thumb, Restaurant A and Restaurant B are both worth $750,000.
Would a reasonable buyer elect to pay $750,000 for an operation with leased assets, declining revenue, and a near-term rent-spike, as compared to one that owned everything and had increasing revenue?
Weaknesses
As illustrated, one may want to make adjustments based on whether or not the business is performing better or worse than the industry average, if the equipment is leased, if sales trends are going up/down, if the restaurant is operated out of a location with a favorable lease rate, or many other factors that will affect future revenue.
On top of all this, profitability, a key benchmark to any successful business, is not considered in this rule of thumb.
These are the main weaknesses to this rule of thumb.
Strengths
On a very abstract, back of the napkin basis, this rule of thumb allows you to quickly come up with a rough approximation of what you may think the business is worth. Of course, this assumes you have 100% confidence that the reported figures are accurate, that all expenses are being covered, and that it will operate like this for several years to come, regardless of a change of ownership.
Rule of Thumb Example #2: Two to Four Times Earnings
Another rule of thumb considered by many is two to four times earnings, abbreviated as:
2-4x Earnings
This one appears to be more useful on the surface, especially because it seems to account for differences in profitability. Less profitable restaurants would likely sell for closer to the two times mark than the four times, and the opposite should also be true.
However, what is the earnings stream to apply this multiple to? It could be net income, earnings before interest, taxes and depreciation (EBITDA), net cash flow, or seller’s discretionary earnings (SDE). Many rules of thumb do not specify which income stream to use and all income streams are calculated differently and return a different number.
For most relatively small operations (under $3M), the earnings stream that applies for use with a rule of thumb is seller’s discretionary earnings (SDE). There are some variations to the SDE calculation, though a basic version can be calculated as follows:
A non-operating expense can be anything from personal groceries purchased through the business to a race car buried in the advertising budget. The hard part about identifying them is that they are often buried in the accounting for the business and the analyst must look carefully to identify them. Further, one may argue they are “necessary” while another may deem them completely frivolous, such as a “business trip”.
Let’s assume that our restaurant has seller’s discretionary earnings of $250,000. According to this rule of thumb, the value of the business could be two to four times this amount:
Weaknesses
As can be seen, without even getting into the details of income/expenses nuances that may inflate or deflate what they are reporting as income after taxes, this one rule of thumb may produce a value from $500,000 to $1,000,000, or a 100% difference.
So how does one decide where the subject restaurant should fall in this range? A buyer would vote for the former and a seller the latter.
As a general gauge, if the business is more profitable than the industry average, the higher number may be more appropriate, and vice versa. So how does one determine if the subject business is more profitable than the industry and what is the appropriate multiple to use? It could be 2.5 times, 3.4 times, or perhaps even greater than four if the business is exceptional. As illustrated, choosing which “thumb” to use to measure value can be a subjective process.
Strengths
Perhaps the best strength of the 2-4x SDE rule of thumb calculation is that it can provide a quick and easy back of the napkin value range. Based on your cursory review of what you think of the facts, you can deem the low or high end of the range more appropriate.
This could be useful if you are looking at buying a business that you are already familiar with, to establish a roughed out idea if the asking price is within the realm of reason. However, this is tempered with the fact that without high scrutiny of the details, the value may seem inappropriately high or low, but upon further investigation into the facts, it becomes more reasonable.
Conclusion
There are many different variables that should be considered when any business is appraised that rules of thumb simply are not designed to accommodate. As a result, a rule of thumb calculation within a restaurant/bar operation, or any business, may provide a quick idea of what a business could potentially be worth. But on the flip side, the accuracy of the valuation may suffer greatly due to the fact that an array of important considerations are not taken into account.
A qualified business appraiser is trained to factor those considerations into the determination of value for a business.
Colorado Appraisal Consultants provides business and real estate appraisal services to restaurants and bars. Please contact us for more information.
