Restaurants: A Study in the Importance of Selecting the Right Comparable Companies
Previously, I wrote about the valuations of the limited-service restaurant and full-service restaurant industries via their publicly-traded constituents. In this article, I will explore what happens when you analyze all of these companies in aggregate and (hopefully) demonstrate the importance of selecting the right comparable companies (also referred to as “guideline companies”) for any valuation analysis. This is of particular importance to those who are currently in the process of completing their mark-to-market analyses to submit to their auditors. Many major audit firms’ valuation specialists carefully examine the comparability of guideline companies in assessing the reasonableness of fair values of portfolio companies under ASC 820. The selection of proper guideline companies not only impacts the current multiple selected, but the “calibration” analysis that is performed, which tests the reasonableness of how a portfolio company’s value changes from one measurement period to the next.
Important notes: I recommend reading my prior posts on limited-service and full-service restaurant companies before continuing with this article. This piece will touch on the same trends and concepts discussed in those previous sections and make comparisons. For additional information on the basic concepts of risk and return and how they apply in the context of this article, please visit: What is Value and Risk and Return in the Market Approach.
The industry constituents for this analysis are listed below and are the same used in the prior analyses of these industries.
The median enterprise value (“TEV”), median revenues, and median EBITDA for all of the publicly-traded restaurant operators are summarized in Figure 1 below (note that “LFY” means latest fiscal year and “LTM” means latest 12 months).
Figure 1 presents an industry that broadly experienced a ~5% increase in enterprise values despite median declines in revenue and EBITDA in excess of 10% and 35%, respectively. In my prior analysis of limited-service restaurant operators, I had observed a substantial increase in enterprise values in the midst of a slight decline in revenue and EBITDA. Full-service restaurant companies, on the other hand, had experienced a slight decline in enterprise values and sharp declines in both revenue (nearly 20%) and EBITDA (nearly 50%). It is clear that, when looking at the industry in aggregate (especially where two subsets of the industry have performed in such a polar opposite manner), interpretations of historical performance can be skewed significantly.
The misleading financial metrics and enterprise value measurements manifest in distortions in the multiples. See below in Figures 2 and 3.
One of the first major issues in aggregating all of the restaurants in one group is a distortion of the valuation multiples. As an example, until 2020, EBITDA multiples for the limited-service restaurants historically fluctuated between approximately 13x and 15x LTM EBITDA, while full-service restaurants were consistently observed at around 10x LTM EBITDA. As of December 31, 2020, multiples for both groups increased (~20x LTM EBITDA for the limited-service restaurants and ~25x for full-service restaurants. The median multiples presented in Figure 3 above reflect an approximate average between the multiples of the limited-service and full-service restaurants. Therefore, using a multiple based on the total restaurant group would result in either an overvaluation or undervaluation.
Analyzing Financial Metrics (the Wrong Way)
Growth often has a strong influence on how multiples differ among companies in an industry, but only a proper comparison will yield meaningful analysis. The consensus revenue and EBITDA forecasts are summarized below in Figure 4 and 5 (“NFY” means next fiscal year; NFY = calendar 2020 for most companies).
The growth trends reflected in Figures 4 and 5 differ significantly from those presented in my previous articles discussing limited-service and full-service restaurant groups individually. In analyzing the industry as a whole (rather than in its subsets), the true historical and projected financial performance of limited-service and full-service restaurant groups is lost, rendering any comparative analyses somewhat meaningless.
For example, SaladCo is a chain of limited-service salad restaurants, which experienced some modest declines in order volume in 2020 due to the pandemic and economic climate. Because it was well-positioned geographically to its customers and able to pivot quickly to offer food for delivery, SaladCo maintained its revenues relatively well in 2020. Going forward, SaladCo is anticipating modest revenue growth in 2021 and 2022 in accordance with an industry expectation for competition to resume as social distancing restrictions are lifted over the course of the next few years. If one were to compare SaladCo to the projected trends in Figure 4 above, a conclusion might be reached that the company performed well in 2020 relative to its publicly-traded peers, but is expected to generate sluggish growth going forward. However, if one were to compare SaladCo to the limited-service restaurant group, its growth prospects would be viewed as typical. Differences, such as this example, could result in an incorrect assessment of SaladCo’s value.
Sometimes It Helps to Aggregate
Looking at broad industry groups is not always a complete waste, though. One positive aspect of combining different industry segments is the ability to see relationships between various financial metrics and valuation multiples due to the increased number of data points. In my prior articles, I pointed out the existence of a relationship between NFY (projected 2020) EBITDA multiples and NFY+2 (projected 2022) EBITDA growth rates. This relationship was seen for both limited-service and full-service restaurant groups and is made clearer by analyzing all of the restaurant operators together in Figure 6.
Similarly, my observations for limited-service and full-service restaurants around profitability and its positive impact on revenue multiples is further solidified in Figure 7 below.
Tying It All Together
If you’ve gotten this far, you should have a better understanding of why it is important to select the right comparable companies when conducting any kind of benchmarking or when performing a business valuation. The wrong group can (and many times will) have a notable impact on these comparisons and will likely lead you to the wrong valuation.
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