Valuation Factors for a Franchise

On the southeast corner of a major, urban intersection is an established privately-held "fast food" hamburger restaurant. On the northwest corner of the same intersection is a McDonald's restaurant.

Both have been in business the same length of time. Both have similar access to auto and pedestrian traffic. Real estate and improvements are virtually identical. Both have annual, after-tax net cash flow of $150,000 and are expected to maintain that level of cash flow for the foreseeable future.

What are the values of the two restaurants? Most people would answer that the McDonald's is worth more.

However, since value represents anticipated future cash flow discounted to present value, how can this be? The answer lies in the discount rate that is developed by consideration of all elements of risk the business is exposed to, or the existence of the franchise itself.

As we'll explain, these two elements are really mirror images of one another. For example, the discount rate developed in the valuation of the privately-held restaurant reflects the business risk for this particular type of restaurant at this location in this given economy - but without the protection granted by the existence of a national franchise. Thus, the value of the "food delivery" aspect of the McDonald's restaurant is the same as that of the privately-held restaurant.

The differential in value can be viewed in one of two ways: 

-The developed discount rate is lower for the McDonald's because of its affiliation (through a franchise) with an established, national presence. This obviously lowers business risk. With less business risk, our denominator in discounting future cash flow is less thereby resulting in a higher value. (Discounting the same future earnings stream yields a larger result as the discount rate gets smaller.) 

-The "food delivery" values can be viewed as equal. Through other approaches, perhaps the current selling price of a franchise by the franchiser in an equivalent market, the value of the McDonald's can be determined as the sum of the "food delivery" value and the value of the franchise agreement itself.

Now, consider the possibility that the main franchiser fails. What will become of the value of its franchisees? All other things being equal, the value will decline to the equivalent value of their non-franchised brethren.

Clearly, the financial success of a franchiser is responsible for a portion of the value of its franchisees. Therefore, the value of a franchised operation cannot be determined without consideration of the financial strength and stability of the franchiser. These attributes relate to specific business risk and must be factored into the development of the discount rate before applying the income approach to valuation.