Understanding the value of your restaurant isn't always necessary for day-to-day operations. However, if want to sell the business, buy out a stockholder or need a valuation for insurance purposes, it's important to get an accurate figure. The cost approach, income approach and market approach are the three most popular methods for valuing restaurants.
Restaurants that have a large amount of specialized or expensive assets may want to use the cost approach for business valuation. For example, a barbeque restaurant with a specialized smoker or an upscale restaurant that owns an expensive building may benefit from the cost approach. Under the cost approach, the value of the business is the sum of restaurant's assets. The most basic cost approach is to calculate the total book value of assets from the company balance sheet. However, book value doesn't always reflect asset value appreciation. To account for this, the analyst can adjust the assets to fair market value and calculate the adjusted asset total.
Most buyers purchase a restaurant based on the potential revenue and income from the enterprise. This approach makes the most sense for casual dining restaurants that may not have significant assets but do command a strong profit margin. The income approach measures restaurant value by estimating future cash flows. The analyst begins the calculation with net income from the company income statement. She then adds or subtracts certain expenses, like unnecessary expenses or non-cash expenses, to normalize the income. From there, the analyst applies a capitalization or a discount rate to account for business risk and the chance that income will decrease.
The definition of fair market value is the amount a willing buyer and willing seller would agree upon. In that perspective, it makes sense that the market approach measures value by looking at what sellers paid for similar businesses. The market approach accounts for factors that aren't as apparent in the other methods, like the potential revenue growth for a restaurant in a gentrifying neighborhood or cutting-edge consumer food preferences. To calculate value under the market approach, the analyst first must find market data for sales of restaurants in the area. Next, the analyst identifies the businesses that have sales levels and operations similar to the restaurant in question. The analyst can calculate the average amount paid per dollar of net sales and apply the rate to the restaurant to determine value.
The final restaurant valuation can vary significantly depending on the method used. The cost approach, especially the book value method, tends to underestimate the value of the business. Since most restaurants are more than the sum of their parts, the cost approach creates a price floor for valuation. The income approach can lead to artificially high results if the analyst underestimates business risk or doesn't understand the true costs of running the restaurant. The market approach can be more objective, but only if the analyst has an ample supply of market transactions that are truly similar to the restaurant being valued.