Whether you’re looking to buy a McDonald’s restaurant, sell a restaurant, gift some ownership to a Next Gen, or are just plain curious, the question of value is of primary concern. Ask any valuator worth their salt and he or she will tell you, valuation is an art, not a science.
There is no black and white formula for determining what a McDonald’s franchise is worth. However, there are time tested and generally accepted methods within which one can work to derive a fair value.
The term value can sometimes be construed as vague and somewhat illusive, but within the constructs of valuation, it is more narrowly defined as “fair market value.” Fair market value, which is the standard of valuation, is defined in IRS Revenue Ruling 59-60 as:
The price at which the property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts.
Court decisions frequently state in addition that the hypothetical buyer and seller are assumed to be able, as well as willing, to trade and to be well informed about the property and the market for such property. As was mentioned previously, there are numerous methods by which to conduct a formal valuation, so one of the first steps that should be taken is to determine the most appropriate valuation method for the subject being valued.
Determine the Best Method
The factors, guidelines, techniques and considerations outlined in IRS Revenue Ruling 59-60 are often categorized into three approaches for valuing the interest of closely-held businesses, like a McDonald’s restaurant franchise. Without going into the nitty-gritty details of each, the three approaches outlined in Revenue Ruling 59-60 are:
- The asset approach
- The income approach
- The market approach
Of the three, the most widely accepted and appropriate method for valuing a McDonald’s restaurant franchise is the income approach so this is the method we will discuss today. The income approach uses the capitalized or discounted future cash flows method. In essence, when valuing this type of asset, what are you really valuing? It’s the stream of future cash flows that can and will be derived from operating the restaurant.
When using the income approach to valuation, one would then employ the discounted future cash flow method as a way of coming up with the estimated value of that future stream of cash flows. The method is premised on the concept that value is based on the present value of the future cash flow to the owner(s) of the franchise.
It recognizes that from an investor's point of view, the value of a particular business, or an interest in that business, is the present value of the economic income expected to be generated by the investment. But, before we can come up with an estimated value of those future cash flows, we first need to have realistic and informed cash flow projections.
The discounted future cash flow method is a powerful tool in valuing franchises and other cash flow driven businesses.
The discounted cash flow method requires a forecast, or projection, be made of future cash flows going out far enough into the future until a point is reached where a stabilization of cash occurs. Future cash flows are then discounted back to the present value at an appropriate discount rate.
The discount rate is simply the rate of return (on the investment) an investor would require based on the perceived investment risk. At the final projection year a “terminal value” is determined, representing an estimated value for all cash flows occurring after the terminal period. The terminal value is then discounted (at the discount rate) to its present value today.
These cash flow projections are the meat and potatoes of the entire valuation, and so they should receive a high degree of scrutiny and consideration. When building cash flow projections, it is critical that one considers all the internal and external economic factors that affect your McDonald’s restaurant and therefore your business.
Also, do not forget about G&A costs. Many times when valuations are prepared, they do not include, at a minimum, a standard G&A cost. This G&A cost will reduce the overall cash flow of the restaurant.
Factored into the cash flow projections should always be any known, necessary, or required capital reinvestment, such as major remodels, restaurant rebuilds, or equipment purchases. As with most businesses, remaining competitive requires re-investment, so this is a piece of the puzzle you do not want to leave out.
Some of the things related to reinvestments that affect the future cash flows are the associated debt payments, any stoppage in restaurant operations for temporary closures, expected sales increases post reinvestment, future cost efficiencies from upgraded infrastructure and equipment, etc.
The determination of the appropriate discount rate is by far the most difficult and subjective aspect of valuation calculation. As I said before, business valuation is not a precise science, and the perception of value of a business is influenced by personal opinion and investor risk tolerance.
Higher sales volume restaurants will generally warrant higher discount rates because there is more risk associated with sustaining the sales levels projected, and the larger sales volume stores are more vulnerable to the impact of a competitor encroaching on their market territory. Opportunities for growth, sales trends, the McDonald's franchises and lease terms, and the availability of capital are all factors that influence the risk associated with an investment in a McDonald’s franchise.
Beware of the Cash Flow Multiple
An attractive, yet oversimplified concept when dealing with valuations is that of the cash flow multiple. It is very important to note that simply assigning value based on a cash flow multiple is not a true valuation approach, but rather a quick and dirty, back of the envelope exercise that can be utilized to test for reasonableness, but not much more. Be wary of those touting the cash flow multiple as a way of accurately valuing a McDonald’s franchise, or any business for that matter.
Pulling it All Together
Once you’ve projected the future cash flow stream of the restaurant, factored in all of the reinvestments and other deductions from the cash flows, applied your discount rates, and brought the resulting values back to today’s dollars, you’ll be left with your estimated value of the enterprise. Now all that remains is the final negotiation! As the saying goes (sort of) – true value lies in the eye of the beholder …
Clearly, the topic of valuation is a complicated one. While getting it exactly right is almost impossible given the immense subjectivity of the endeavor, getting the best possible price relies on the thoroughness of the work being done. This of course means having a talented and qualified CPA in your corner is a must! Please contact us if you have any questions about the value of your McDonald's restaurant.