Business Valuations: What’s Behind High Multiples?

During the mid-to-late 1990s, many people enjoyed enormous returns from their investment portfolios. Almost every publicly-traded equity investment provided double-digit returns and growth. Investments, such as dot-com companies, would form with an idea/product/service, go public, and watch their stock prices soar due to rampant speculation by investors. But factors such as a poor business plan – and, in many cases, lack of sales and profitability – brought the good times to a screeching halt shortly after the turn of the century.

Did investors learn a lesson? Looking at restaurant IPOs, the answer appears to be “no.” Speculation is not dead. However, unlike the dot-com bubble, the restaurant industry has more historical empirical evidence to support projected hopes of growth and sustainability. According to firstresearch.com, the U.S. restaurant industry includes approximately 550,000 restaurants and generates more than $400 billion per year – or almost $1.1 billion per day. Furthermore, domestic demand for eating and drinking places is forecast to grow at an annual compounded rate of 4 percent from 2013 to 2017. It was only a matter of time before investors started looking at the restaurant industry as a place to put their funds.

Like virtually all investors, restaurant-industry investors are looking for concepts that have good growth potential. Investors want to be in on the ground floor of the next Chipotle Mexican Grill, which trades at approximately 20 times its opening day valuation, or Potbelly Sandwich Shop, which saw its stock price double on the first day of its initial public offering.

Given that most restaurants are not going to go public, how can the privately-held restaurant position itself to enjoy these higher valuations in a potential sale? Since business appraisals are basically prophecies of the future, the restaurant owner must not only find the right leadership team, concept, location, décor, menu, and ambiance for its target market, it must ensure that its financial metrics are working, since past financial success is a very important indicator of future viability.

Higher multiples can be realized when a concept can prove it can generate growth, not only in sales year-over-year, but also in gross and operating profit. In addition, investors like to see:
  • Prime costs below 60 percent of revenues.
  • Expansion funded primarily by cash flow from operations rather than outside funding.
  • Expansion to locations with different market demographics, illustrating a concept’s portability.
  • History of performing well during economic downturns.
Successfully accomplishing these checkpoints has resulted in actual transactions of almost 20x EBITDA for restaurant concepts that are privately owned and with operating histories of less than five years. While this success may be more the exception than the rule, it highlights the tremendous potential to an equity owner if the restaurant caters to its finances, as well as to its customers.

If you can combine a history of successful financial performance and expansion with a popular concept, investors will likely take notice. Your restaurant may not be the next Chipotle, but you can position it to enjoy a nice return on investment when it’s time to sell.

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