In this article I’m going to look at how to value licensed restaurants or cafes for the purposes of selling a business (using “fair market value” in an asset, not share, sale). The same approach can be used to value most hospitality businesses including non-licensed cafes and restaurants, and bars.

Sample Cafe Profit and Loss

Sample Cafe is a healthy cafe business in a normal precinct in a normal city. As you can see from the figures below, it is increasing revenue by 6-7% over the last three years, while keeping tight control of costs.

Gross Profit % is 67%, rent is 7% of revenue, wages are increasing at a slower rate than revenue. This is a good healthy hospo business showing year on year growth on the top (sales) and bottom (profit) lines. Sometimes owners struggle to keep Gross Profit % in the high 60s, or rent below 10% of revenue (revenue or rent issue), or expenses get out of control. But not Sample Cafe, it’s as though it was an artificial creation ;).

Figure: Sample Cafe Profit and Loss (standard)
Sample Cafe Financial Profit and Loss

Put yourself in the buyer’s shoes. They are buying future maintainable income and the best indicator they have is the last 3 years of historical accounts. These accounts are showing growing earnings with the big components (revenue, cost of sale, labour, rent and overhead) all performing well. It seems reasonable to expect the figures to at least remain at the 2017 result and possibly even continue to improve—there isn’t anything indicating a big risk to those future profits based on financial analysis alone.

Normalise Earnings

Now let’s normalise the earnings.

We want to remove interest (paid and received, and principal) because capital structure is a buyer decision, they may choose to have more or less debt, depending on their equity and willingness to carry debt. We remove items by adding back the expense (or subtracting the revenue) to the Net Profit Before Tax.

We want to remove depreciation because that is an artificial calculation made for the purposes of tax not the actual decline in value of the asset. On the other hand we want to make sure there is some expenditure in the accounts for maintaining or replacing assets (“maintenance capex”), in this case repairs & maintenance seems to cover it.

Being a small business we want to include the owner’s or “proprietor’s wages” as this is part of the profits of a small business. If it was a business which has, say, 5 cafes then we may choose to not do this as it has crossed a line from being an owner’s business where the owner’s wage is regarded as profits to mid market business where the owner’s wage is a true management expense.

In this cafe there is only one working owner. If there were two or more then we would need to look at industry figures to see much of all their proprietors’ wages we should include.

Like many small business they have an office at home, or at least they do for tax purposes, like depreciation we exclude that cost.

This cafe has a motor vehicle expense but doesn’t deliver, and suppliers drop off product. The vehicle is not needed to run the business and is probably included for tax purposes, so we’ll take it out.

Every year the owner travels overseas to research the latest trends in hospitality. On reflection the owner is not convinced that the business needs this research to generate earnings.

Finally, an asset was sold for less than it’s book value which resulted in an accounting loss, this is a non cash item like depreciation.

This increases the earnings from Net Profit Before Tax of $219,050 to normalised Earnings Before Proprietor’s wages Interest Tax Depreciation and Amortisation (EPBITDA) of $366,750.

Figure: Sample Cafe Profit and Loss (normalised EBPITDA)
Sample Cafe Normalised Earnings

Does the cafe owner believe that earnings will at least stay the same for the next year or two. Is there any reason to believe that the future maintainable earnings will be at least $366,750? If so, then we will use $365,000 (rounded to the nearest $5000) as our earnings figure for the purposes of calculating business value.

Balance Sheet

In the case of a healthy hospitality business, the balance sheet isn’t usually of much interest because we’re not selling shares.

We want to know stock at cost because you usually sell a business for a price plus “stock at valuation” (SAV) but even then an estimate will do at the valuation stage.

If you own the property, then you’ll need to remove this asset from the business and add a lease. The lease cost should be then included as an expense in your calculation of earnings (you have removed the principal and interest payments when normalising the accounts).

Very rarely, a hospo business may be a share sale rather than an asset sale. This could be to protect good liquor licensing conditions or to avoid assigning or transferring leases or other agreements to the buyer’s company. However, the downside is that the buyer also incurs liabilities, including hidden liabilities, which is why small businesses usually sell on an asset basis.

Business Valuation

There are three principles of valuation: Principles of Anticipation, Substitution and Reproduction.

The Principle of Anticipation is where we value the current worth of future benefits of the business, and use the Income-based valuation methodologies including Discounted Cash Flow, Capitalised Earnings, and Multiple of Discretionary Earnings methods.

The Principle of Substitution is where we value a business based on the cost of acquiring an equal substitute, and have the Market-based valuation methodologies especially the Direct Market Data method.

The Principle of Reproduction is where we value what it would cost to establish a similar business, and have the Asset-based business valuation methodologies including the Asset Accumulation method.

In practice the most important ones for the hospo industry is the Direct Market Data checked by Capitalised Earnings and Multiple of Discretionary Earnings methods (and some argue Gross Revenue Multiplier but see my comments below). Let’s look at Direct Market Data.

Principle of Substitution: Direct Market Data Method

Also known as the Comparative method. Using this method you find the earnings multiples of similar businesses, adjust for differences, and multiply by your earnings to arrive at fair market value. The justification for using the approach is to not pay more for one business than a similar one down the road. It is used by billion dollar corporate valuations, mid-market private equity buy outs…and small business sales.

The service NZ business brokers use for small businesses is BizStats. It acts as a NZ database of business sales statistics and you can access this for a fee. You nominate the number of business sales, an industry and some other data. They send you back some statistics. It’s a good service and I recommend it. If you use a business broker then they will certainly look at and contribute to it.

It calls earnings ‘EBPIDT and “Sellers Discretionary Cash”‘, which is the same as our EBPITDA. It will include location, sales revenue, gross profit and some other information. This information allows you to see if your business really is comparable to others. Most importantly it includes “Selling EBPIDT Multiple”.

“Selling EBPIDT Multiple”, or Earnings Multiplier for short, is the Sale Price / EBPITDA. For mid market sales ($2-50 million+ sales) we use the same thing but call it “Transaction Comparatives” which is Enterprise Value / EBITDA. Enterprise value is the equity plus debt less cash. When Restaurant Brands New Zealand Ltd purchased QSR Pty Ltd in early 2016 their respective investment bankers would have been arguing transaction comps (ended up 7.15x). No matter the size of business the multiplier is key, along with the earnings figure.

Looking at the last few years of data for licensed cafes (not restaurants, bars or unlicensed cafes) shows the average EBPITDA Multiplier is 2.32x. It is likely that a licensed cafe will be sold for between 1.40 and 3.23 multiplier (based on 1 standard deviation i.e. 68% chance).

There is a strong correlation between EBPITDA multiplier and revenue (correlation coefficient of 0.91). In other words, it is likely that the higher the multiple, the higher the business revenue. Of course, it is likely that a larger business will be more successful—correlation is not causation.

And, having said that, the actual data shows many instances where larger businesses have poor earnings which lowers valuations. Earnings are at the heart of business value not revenue, and revenue rules of thumb should be carefully used (e.g. restaurant value = 30% of revenue).

There is a poor correlation (0.25) between EBPITDA multipliers and Gross Revenue multipliers confirming my belief that using gross revenue rules of thumb such as 25-35% of sales or 14-15 weeks of revenue are poor estimates of value.

Back to the market data. You’ve looked at location, sales revenue, EBPITDA and perhaps gross profit, number of working owners, tangible asset value and stock. You see three that are directly comparable.

You see the EBPITDA multipliers are similar (hopefully). Now its time to apply a little bit of subjectivity.

How good is your lease, is there any seasonality issues, how about neighbouring developments that may reduce/increase revenue, does the establishment fit the demographics of the location, is a new cafe opening up next door…

Adjust the EBPITDA multiplier accordingly. Lastly, give a range, the more uncertainty about future maintainable earnings the wider the range.

To calculate business value you simply multiply EBPITDA by the multiplier.

Let’s say direct market data suggested a multiplier of 2.90x.

EBPITDA is $365,000 from above.

Business value = $365,000 * 2.90x = $1,058,500 (plus SAV, plus GST if any), round up to $1.06 million.

Principle of Anticipation: Multiple of Discretionary Earnings

In a practical sense, this is a version of using a capitalisation rate i.e. when someone buys a building they divide the rental profit by a cap rate %. If the cap rate is 10% and profits are $1million then the building is worth $1million/10% or $10million. The equivalent multiplier of a 10% cap rate is 1/10%=10x. A 25% cap rate is 4x, 33% is 3x, 50% is 2x. The higher the cap rate, the lower the multiplier, which reflects a higher risk. Note that a building is always regarded as a less risky investment than a small business. A cafe will like sell between 1.4 and 3.23 which is the equivalent of 71% and 31% cap rate—much high risk than bricks and mortar.

What’s your multiplier?

Here is one method based on the US organisation Certified Business Brokers Appraiser’s Analysis Table, with my notes (NB) attached. I’ve changed the scores to increase the multiplier up to 4.5x which is about as high a multiplier you’ll see in the hospitality industry (higher than 4.5x will be for companies that own a number of hospo businesses including master franchisers).

10 Historical Profits
0.1-1.5 Negative to break even
1.6-3.0 Positive, but below industry norm
3.1-4.5 Industry norm or above
NB: the New Zealand licensed cafe EBPITDA/Revenue norm is 17%.

9 Income Risk
0.1-1.5 Continuity of income at risk
1.6-3.0 Steady income likely – three to five years
3.1-4.5 Profitability assured – five plus years
NB: “Income” as in EBPITDA.

8 Business Growth
0.1-1.5 Declining and further decline likely
1.6-3.0 Flat or at inflationary levels
3.1-4.5 Rapid growth with more expected
NB: IMO 4.5 Rapid growth means 20%+ revenue growth for the last three years

7 Terms of Sale
0.1-1.5 Seller requires all cash
1.6-3.0 Reasonable terms available
3.1-4.5 Exceptional terms available
NB: exceptional terms refers to deferred payments such as vendor financing or payment based on performance

6 Business Type
0.1-1.5 Service business with few assets
1.6-3.0 Equipment and/or inventory are significant component of total value
3.1-4.5 High cost of entry, equipment and/or inventory are major component of total value
NB: the average cafe sale has tangible assets that make up about 50% of a normal sale price, so I’d choose about 2.5

5 Location/Facilities
0.1-1.5 Less than desirable to tolerable
1.6-3.0 Acceptable to average
3.1-4.5 Above average to superior
NB: How long does your lease have to run and are there any clauses of concern e.g. demolition. Are you very close to a wealthy workforce or local community, what’s your foot traffic like, how expensive is your fit out and how well has it been maintained or replaced?

4 Marketability
0.1-1.5 Limited market – special skills required
1.6-3.0 Normal market – needed skills available
3.1-4.5 Large market – many qualified buyers
NB: the buyer can employ a qualified chef, so should be a large market.

3 Desirability
0.1-1.5 No status, rough or dirty work
1.6-3.0 Respectable and satisfactory
3.1-4.5 Challenging and attractive environment
NB: certainly not middle to high, what will the buyer think?

2 Competition
0.1-1.5 Highly competitive and unstable market
1.6-3.0 Normal competitive conditions
3.1-4.5 Little competition/high start-up cost
NB: can two other cafes open up nearby? Probably, and this is the downside of the hospitality industry, it is easy to start up a hospo business even if it’s hard to run them well.

1 Industry
0.1-1.5 Declining and further decline likely
1.6-3.0 Flat or at inflationary levels
3.1-4.5 Rapid growth with more expected
NB: In the case of hospitality it is probably more related to the vibrancy of your precinct. The industry as a whole is doing well with NZ growth rates of about 9% pa over the last 5 years (Hospitality NZ Market Insights Report 2017).

I’d then upweight “Historical Profits”, “Income Risk” and “Steady income likely”.

For Sample Cafe, I have assessed as follows:

10 Historical Profits
3.5 Industry norm or above

9 Income Risk
3.0 Steady income likely – three to five years

8 Business Growth
3.1 Rapid growth with more expected

7 Terms of Sale
2.0 Reasonable terms available

6 Business Type
2.5 Equipment and/or inventory are significant component of total value

5 Location/Facilities
3.0 Acceptable to average

4 Marketability
3.1 Large market – many qualified buyers

3 Desirability
2.5 Respectable and satisfactory

2 Competition
1.0 Normal competitive conditions

1 Industry
3.0 Flat or at inflationary levels

The total of “Historical Profits”, “Income Risk” and “Steady income likely” is: 9.6. I’ll increase this by 50% to reflect the importance of financials: (9.6*150%)=14.4.

The total of the rest is: 17.1

Add them together and divide by 10 for the number of factors (14.4+17.1)/10 = (31.5)/10=3.15.

Results in an earnings multiplier = 3.15x.

Check the cap rate equivalent: 1/3.15=32%, seems fair.

To calculate business value you simply multiply EBPITDA by the multiplier.

EBPITDA $365,000 * 3.15x = $1,149,750 (plus SAV, plus GST if any), round to $1.15 million.

Final Appraised Value

We have a valuation range of (Direct Market Data) $1.06 to (Earnings Multiplier) $1.15 million.

We’d check this value with methods including the Basic Method, Excess Earnings, and average industry Gross Revenue multiplier. We’d also do a sanity check—if we added in some working capital to the appraised value, would the return on the investment make sense for the level of small business risk?

The range is (conveniently) tight so I’d appraise the value of this business at $1.1million (plus SAV, plus GST if any).

I’d probably advise the client to price the property a bit higher to give some negotiation room but some clients just stay with that price.

Chances are your business is not quite as rosy as this one, it is unlikely likely to have consistent revenue and earnings growth for example. If you reduce the earnings and the multiplier your appraised value could quite quickly drop to $200,000 to $400,000, frankly, a much more likely circumstance than $1 million.

If you’re not making positive EBPITDA then the appraisal will be on the basis of asset value and, truth be told, you could be heading towards more of a liquidation situation than a business sale.