Someone asked me a question about a stock I own called
Ark Restaurants (
Right now the stock price is $21 vs. a 10-year average FCF of
only $1.68/share and a FCF margin of less than 4%. I appreciate
that they are good stewards of the shareholders' money in
returning cash in the form of dividends. It looks like in the
last 10 years they've not retained any earnings -- they're
returning all the earnings to shareholders. At the same time,
revenues are nearly flat and FCF is not growing. Looking at it
through this admittedly myopic lens, it looks like my return on
investment is going to be roughly in line with the FCF yield of
8%, presuming no future growth...Can you help me put this all
That's a great question. The first thing I want to say is that
this isn't really an article about Ark Restaurants. I own the
stock. But I don't think it's the kind of stock most people
reading this will have any interest in. What should interest
everyone, however, is why I think a can get a good return in the
After all, if the stock is trading at an 8% free cash flow yield,
and it isn't growing - how can you ever make more than 8% in the
The key reasons you might get a better return are:
One, it actually will grow a little.
Two, it will take very little retained earnings to grow.
Three, the stock is undervalued and this undervaluation will
close over time through a rising stock price.
Four, there is the possibility that something will happen within
just a few years to give you a high annualized return.
Those are common reasons for buying a stock when the free cash
flow yield alone is not high enough to justify an investment. In
this case, it's about 8%. That's not low. In fact, most stocks
trade for much more than 12 times their 10-year average free cash
flow. But the question is asking whether the stock is doomed to
return only 8% - or whether it might return 8% or more under some
I bought the stock. So, I obviously think returns above 8% a year
are possible. How can that be?
Let's start with the company's long-term history.
Over the last 22 years - as far back as EDGAR has sales data for
Ark - the company has grown sales by 5.9% a year. As they say in
their reports, they do not normally experience same store sales
growth over time. This is typical of restaurants that are run as
separate businesses with their own brand names, locations, etc.
unlike the national "concepts" like Chipotle and McDonald's and
Darden and OSI and Cracker Barrel and all of those. These
restaurants - although located in hotels, casinos, landmark
places, etc. - are basically each like your local restaurants
near where you live and where you probably go out and where no
one from just a couple towns over has ever heard of. These are
like those businesses. You mentioned BDMS. This has a similarity
to those in the sense it's ultimately a local business at the
individual store level.
Now, to me, 5.9% annual growth looks a lot like nominal GDP
growth. So that has me interested. I like the idea that growth
may create value (because it may require less capital than
growing the same amount at other companies, investing in the
S&P 500 might cost, etc.). Here is one way I think of it.
Assume I believe that the S&P 500 will return 7% a year over
the next 15 years. Now, how much will it cost me to grow through
the S&P 500? It will cost $1/0.07 = $14.29. If I believe the
S&P 500 is priced to return 7% a year, then I have to put
$14.29 in the S&P to get one dollar of wealth growth this
Now, let's think about Ark. Ark has - using your 10-year number -
about $1.68 a share in normal free cash flow. The stock costs
$20.31 a share as I write this. So it costs me $12.09 to grow my
wealth by $1 using Ark's free cash flow. This is a bit better
than my estimate of what it would cost me to invest in the
S&P 500 with the idea of holding my shares for the next 15
years and earning 7% a year. It is also, a lot lower than the
probably a little over 16 times free cash flow at which the
S&P 500 normally trades. Also, a quick check at GuruFocus
tells me that the S&P 500's Shiller P/E is currently 23.
Ark's Shiller P/E - if we substitute free cash flow - would be
12. The S&P 500 has tended to grow around 6% a year. Just
like Ark. In fact, if we look as far back as we can into Ark's
history and as far back as we can into the Dow Jones history
(which is further than the S&P 500) we will see both tend to
compound at a little less than 6% a year.
Finally, we have the question of what the growth is worth. I
think Ark can make the growth more valuable than the S&P 500
by growing the same amount while retaining less earnings. In
other words, I think Ark's growth will be lower cost. Now some
might argue with me here. After all, the S&P 500 has a higher
return on equity than Ark right now. Ark doesn't use financial
leverage in the form of bonds and bank debt. It does have leases.
I think they are mostly good leases in the sense that Ark is able
to manage a good cash flow generating location without putting in
as much capital as they'd have to if they owned the place and yet
they can - and do - walk away from locations when the lease no
longer makes sense. I also think that Landry's interest - since
they have some business with similar location based restaurant
approaches - supports the idea the leases are not a terrible
weight around Ark's neck.
For these reasons, Ark has been able to earn about 18% on their
capital - as you mentioned in your email. Morningstar - which
doesn't net out cash - gives the number as 15.6%. I'll round down
for the sake of conservatism. And we'll assume Ark can - over a
full cycle - earn about 15% on equity. Meanwhile, we will assume
- this is perhaps too aggressive, we'll see - that Ark will grow
about 6% a year over time. We will use Ark's 10-year past free
cash flow average of $1.68 a share as today's normal "owner
earnings" figure and our starting point.
The key assumptions in our valuation of the company look
something like this:
� Growth of 6% a year
� Cost of growth of $6.67 per $1 of growth (i.e., 15%
� Owner Earnings of $1.68
� Share Price of $20.31
� S&P 500 expected return of 7%
?Let's make this real. Let's say we buy 3,000 shares of Ark for
$60,930. What does that buy us?
It buys owner earnings of $5,040 ($1.68 * 3,000). Now, let's
tackle growth. I have no idea to what extent Ark's sales will be
up or down from year to year. I know about the hurricane. I know
they closed a failed location. I know they signed a new deal for
a new location. I know they bought more of a joint partnership
they were already operating. We won't worry about any of that
here. We are worrying not about what earnings will be next year
but what they will be in a Shiller P/E sense. We only gave Ark
credit for earnings averaged out over 10 years. So, we are only
looking for Ark to lap the last decade by 6% as they go by. In
other words, we are looking for a 6% annual rate of decade over
decade increases in owner earnings. I won't get into whether or
not that is likely right now. I'll just assume it is.
Ark is earning $5,040 on my $60,920 investment right now
(assuming that 10 year average earning power number of $1.68 a
share we are using). If Ark grew earnings by 6% it would grow
what it earned on my investment from $5,040 to $5,342.40. That's
an increase of $302.40. If we assume - as we did above - that Ark
can earn a 15% incremental ROE than Ark will have to invest $6.67
for every $1 of growth it achieves. That means Ark would need to
keep $2,017 of my money to grow my owner earnings by $302.40 for
next year. What happens to the rest? Ark is assumed to earn
$5,040 on my 3,000 share investment. Then they retain $2,017 to
grow by 6%. The rest of that amount - $3,023 - can be paid out in
a dividend or used to buy back stock. I would prefer they used it
all to buy back stock. So let's assume they pay it all out in a
dividend instead. That's a 4.96% dividend yield ($3,023 /
$60,930). However, that yield is before tax. Let's assume I pay a
15% dividend tax. In that case, I get only $2,570 in dividends.
The other $453 goes to the IRS. So, now I have 3,000 shares of
Ark Restaurants (a company that is 6% bigger) and $2,570 to show
for my original investment of $60,930. It is a full year later. I
have earned a 4.22% after-tax yield. This compares pretty
favorable with after-tax yields on bonds, other stocks, etc.
I also have my 3,000 shares of Ark Restaurants and most
importantly the $302.40 my owner earnings grew. Remember, this is
a fantasy scenario. Ark's earnings may very well be lower next
year. We are doing this all based on an assumption that normal
owner earnings are the 10-year past average and future growth
will be 6%. For the sake of explanation, we are making that a
smooth 6% a year rather than a lumpy decline of 10% then an
increase of 18% etc. even though they both get you to the exact
What is the value of that $302.40 increase in my owner earnings?
Well, the Shiller P/E we always talk about has a historical mean
of 16 times earnings. A lot of investors consider a number around
16 to be normal. And in those cases we are talking about earnings
rather than free cash flow. We are using free cash flow as our
gauge of owner earnings. So, I will - despite all the complaints
I can hear about this being a micro cap, a controlled company,
terribly illiquid, etc. and therefore needing a lower P/E -
assign a normal cap rate of 16 times earnings to that $302.40
increase in my owner earnings. That works out to $4,838.40 in an
intrinsic value increase.
So far my investment in Ark Restaurants is looking something like
� Paid $60,930
� Received $2,570 in after-tax dividends
� Experienced $4,838 intrinsic value growth
� Still own Ark Restaurants common stock (a security
with no maturity date)
?Now, we need to tackle that last part. I think Ark Restaurants's
common stock is cheap. Not so cheap that if it couldn't pay
dividends or grow or earn a good return on equity or do any of
the things long-term investors depend on that it would be a good
investment. Ark isn't that kind of cheap. This is not a stock Ben
Graham would put at the very top of his list. This is not deep
value. But it does fit the value stock mold. It is a comparative
value. I think - and I guess Landry's thought - it was a bit of a
private owner bargain too.
I think Ark is a 75 cent dollar. I think that you are paying a
little over $20 right now for a stock that Landry's wanted to buy
at $22 and I think was fairly worth about $28. You can quibble
with my estimate. I won't defend it. It's just the back of the
envelope approach I would take to giving a fair appraisal of the
company. If you use peer comparisons of what EV/EBITDA multiple
other restaurants were sold at and if you do the Shiller P/E
approach you used before (where Ark scores a Shiller P/E of 12
vs. a normal Shiller P/E for the market being 16) you end up with
similar conclusions. If you used a particularly relative to the
moment approach - I'm using restaurant acquisitions over the last
7 years - you could find deeper discounts. For example, the
market has a Shiller P/E of 23 right now versus 12 for Ark. I
won't use a comparison like that. It would be far too aggressive.
It assumes today's stock prices are perfectly correct for the
S&P 500. I don't like that kind of approach.
What does this 75 cent dollar approach tell us?
There are a few reasons to buy a stock. Value investors tend to
focus on the valuation gap. Dividend investors tend to focus on
yield. Growth investors tend to focus on growth in EPS in the
future. Quality investors tend to focus on free cash flow, growth
in free cash flow, and maybe return on equity.
Part of buying Ark today can be seen as a pure investment for
yield approach. We talked about that. We can peg that at 4.22%
after-tax. That's the investment component. Then there is the
growth value of the company. This is a speculative and
contentious issue. No two people will agree on this one. I said
Ark could grow intrinsic value by 6% a year. However, because I
think I am paying $60.930 for something worth $81,240 (75 cents
for a dollar) this 6% growth yield on face is actually an 8%
growth yield at market. In that sense, I think the current buyer
of Ark stock is getting paid:
� 4.22% after-tax in dividends
� 8% in intrinsic value growth
� And still owning a 75 cent dollar
Let's look at that 75 cent dollar. Today, you can pay $60,930 for
3,000 shares of ARKR. I think the actual value - right now - of
those 3,000 shares should be $81,240. This is not based on future
growth assumptions discounted back to the present or something.
This is based on what I think the company should sell for today
in a negotiated transaction. I could be very, very wrong. The
only offer the company got was a $22 hostile offer. So I don't
have a smoking gun here. But let's say you agreed with me that
Ark is a 75 cent dollar.
How does this result in wealth creation for you? Well, you plunk
down $60,930 to buy 3,000 shares of Ark. We assume - at some
point - you will get $81,240 back. Maybe you'll get that from the
open market (if Ark stock rises 33% at some point). Maybe
Landry's will pay that to you in cash. Maybe someone else will
come along and you'll get cash and stock in some deal. Maybe
nothing will happen until the founder (and controlling
shareholder) of Ark dies. I can't answer these questions. Stocks
don't come with maturity dates. That doesn't mean they aren't 75
cent dollars and it doesn't mean that gap won't close.
What does that do for you? Well, it obviously gives you a gain of
$20,310 (before-tax) at some point. Hopefully, it will give you a
long-term capital gain. It might even give you the opportunity to
keep the stock (since the gain comes in the open market) or roll
your stock over into another public company (if someone issues
shares to buy the company). Again, I can't answer those
questions. So, I can't answer when you'll get paid or how much
you'll have to pay in taxes. But the assumption here is that you
will make $20,310 pre-tax at some point. This is your capital
gain. It's equivalent to what a bond buyer of a 75 cent dollar
gets when that dollar matures. Of course, stocks don't have
maturity dates. But I want to avoid the confusion of assuming
that someone buying a bond yielding 13% really wants to collect
13% in interest over time rather than get a capital gain. We
absolutely do not know that. I own two American stocks. Both have
dividend yield over 4%. I didn't buy either for the dividend. I
don't mind the dividend. But if they could just buy back stock
with my dividend I'd be happier in each case.
So now we have the three potential parts of Ark wealth creation:
� The investment component: A 4.22% after-tax dividend
� The speculative component: A 6% growth rate (which
is 8% if bought at 75 cents on the intrinsic value dollar)
� The value component: A $20,310 capital gain (caused
by investing $60,930 in a 75 cent dollar)
?Each of these are potential sources of profit for the investor.
Some are quick and flashy and unlikely. If Ark is bought out by
another company at the price I think it's worth within the next
year, the annual return could be 40%. If the growth never
materializes at all but the capital gain is earned over a period
of 5 years where the value gap closes and I collect dividends
along the way - then the annual return would be 10%. It would
take share price appreciation of 6% a year to turn a 75 cent
dollar into a 100 cent dollar if the dollar never grows. Also,
there'd be that 4.22% dividend after-tax. Before tax, the return
would be about 11% without any growth but with the dividend and
the value gap closing over 5 years.
We can look at the investment this way. It should yield about
4.22% after-tax. For comparison, this is going to be equivalent
to a 5% dividend yield for individual investors. So, there is a
5% a year investment return here. There is also a value return
here. This is the valuation gap. It's a one-time capital gain.
The value return is inversely related to the time you hold the
stock. Let's take a look at how buying a 75 cent dollar works out
over different holding periods:
1 year: 33%
3 years: 10%
5 years: 6%
10 years: 3%
15 years: 2%
Excluding the speculative - growth - component of the stock we
can focus on our expected investment returns by combining the
dividend yield and the capital gain caused by the one-time
undervaluation being eliminated. These are the two sturdiest
parts of our return potential in Ark. When added together they
look something like this:
1 year: 33% + 5% = 38%
3 years: 10% + 5% = 15%
5 years: 6% + 5% = 11%
10 years: 3% + 5% = 8%
15 years: 2% + 5% = 7%
So our return - even with the dividend included - still has the
familiar decaying annual return pattern of a no growth stock:
1 year: 38%
3 years: 15%
5 years: 11%
10 years: 8%
15 years: 7%
Then there is the growth kicker. I won't try to value that. I'll
just say Ark did grow about 6% a year over the last two decades.
And it has earned about a 15% return on equity. Since we are
saying we're lucky to get 7% a year investing in the S&P 500
right now, that means that growth where you earn 15% a year is
obviously value creating. Under those circumstances, a dollar of
earnings retained that earns 15% a year should be valued more
highly than a dollar of earnings paid out in dividends. None of
the investment return calculations of Ark's possible future
returns assigned any value to retained earnings at the time they
were retained. All we assumed so far is that a 5% dividend would
be paid (dividends aren't retained earnings by definition, so
that's irrelevant). And we assumed someone would one day - in the
next 15 years - pay us one dollar for each dollar of intrinsic
value Ark possessed. We also assumed Ark is priced at 75 cents on
the intrinsic dollar.
A buyer - whether in the public market or a private owner - is
concerned with earnings only as a gauge to the future earnings
the company will earn while he owns it. He obviously gives no
value to past retained earnings. He simply estimates future
Therefore, we haven't counted the potential growth kicker. And we
won't. I'll just say it was 6% once. And it is worth more than a
dividend if it's earned as a 15% return on equity. If you want to
assume there is a potential kicker in the stock that could add
more than 6% a year to your returns - you can certainly make that
assumption. I would just caution that it remains - as Buffett
would say - a kicker.
The investment return on the stock itself ranges from about 7%
over 15 years to 15% over 3 years. I consider the 38% return
potential shown under one year to be another form of kicker.
Something could happen in the next year or two. Let's keep that
in mind. But we don't have to quantify it.
So I view Ark as an investment with a 3-15 year time horizon
promising a return of 7% to 15% over that period. I think this 7%
to 15% security has two kickers attached. So to sum up:
� An investment offering 7% to 15% returns
� That could offering a higher "event" return within
the next 2 years
� And that could grow in a way that creates value over
I think it's an especially good combination. The event
possibility - caused by cheapness and an interested competitor -
increases the short-term potential. It's a 75 cent dollar where a
competitor made a hostile bid. That can help goose your chances
on an above average result within 3 years. Then you have a kicker
that could help with the long-term holding period. Without
growth, the returns in this stock will decay from about a 15%
expectation over 3 years (which is quite acceptable) to an 8%
return over 10 years (which is no advantage over alternatives).
Without any growth, the investment's outperformance as an
investment occurs only if the market, a control buyer, etc.
recognizes the intrinsic value I see in the stock within about 5
years. If that doesn't happen, we have a problem. Now, I think
even a relatively small amount of growth - if it's value creating
- can solve this problem and keep Ark stock an acceptable
(although not mind blowing) investment even if held indefinitely.
In other words, I think the potential for some profitable growth
can keep your returns for holding periods as long as 6 to 20
years to be perfectly fine. In my book, perfectly fine is
1. Beats the market
2. Returns at least 10% a year
With even rather slow growth - as long as there is some growth at
a good ROE - Ark can add enough value each year to deliver an
acceptable return over an indefinite holding period. I wouldn't
want to hold it indefinitely. I'd want the 75 cent dollar to
become a dollar dollar within the next 5 years. But I would feel
I could hold it indefinitely. That is very important.
So I think there is enough here to support an indefinite holding
period. I think a holding period of something like 3 to 5 years
is likely to result in good returns. Good enough for me to switch
out of cash and into Ark. And I think there's a lottery ticket
attached where maybe you get really good annual returns through
some event happening within the next 3 years.
Simply put, you've got a higher than average chance of a good
short-term return. You have an above-average medium term return
promised. And I think - if you get any growth - that the
long-term return is something you can live with.
Is Ark the best investment I've ever seen?
No. It's far from it. But I think it's a better investment than
stocks generally, I think it's a better choice (for me) than cash
right now, and I think it offers acceptable returns over all
future time periods. That's all you need to switch from cash into
a stock. And since I was 75% in cash before buying Ark, it was
only a question of comparing Ark to cash. It checks all the boxes
it needs to check to get me out of cash.
When I'm 100% in stocks, I'll let you know. And I'll let you know
how Ark compares to the other things I own and the other stocks I
might want to buy. At that point, it's a different test. Ark
would have to pass the best alternative test. Right now, it's a
low bar because I've got more cash than ideas.
Eventually, something other than cash will be my best
alternative. In that case, an investment priced to offer 7% to
15% annual returns with the potential - probably unquantifiable -
to maybe make a better annual return if something happens in the
next few years, may no longer be good enough.
When the alternative is cash, it's good enough. You always have
to decide on investments relative to your own alternatives. My
alternative here was cash. I was deciding between buying Ark or
nothing. I was not interested in buying anything else. And I had
75% of my portfolio in cash. I wasn't going to put 75% of my
portfolio in Ark. So, there'd be room for another stock even
after buying Ark.
If you're 100% invested in stocks right now, you would need to
use different alternatives to make your decision. You would need
to decide if it was worth selling something you own to buy Ark.
That's a much higher hurdle.
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