I just got an earful from a business owner. We did a valuation of his business, arranged through the president of the company. The president passed the valuation to the business owner, who I had not yet talked to. The owner called me up, and blasted our valuation because the value ended up at around 5 times earnings. He said that was far too low, because he heard that 4 to 5 times EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization) is normal, and he felt he was above normal.
He was so upset I couldn’t even explain to him that we didn’t even use EBITDA. Since his earnings were below $1 million, we used seller’s discretionary earnings (SDE). I later calculated that the recommended selling price, as a multiple of EBITDA, was about 6.5. (Of course, the real problem was that the valuation was at least $2 million below what he expected.)
For this short article, I’m going to have to assume you know the basics of business valuation, and how important earnings are. For a primer, see my articles:
BOTH DE AND EBITDA
Both DE and EBITDA attempt to standardize the earnings number by excluding items that are variable and discretionary from company to company. For example, one company may have a heavy debt load while another may have none. So we exclude interest expense from the both DE and EBITDA. A buyer then calculates what his debt load will be, if any, and can adjust the earnings number to fit his situation. Same with taxes – some companies have different tax strategies, so we use a pretax earnings number. Depreciation and Amortization is a non-cash expense, and also are more of an accounting method rather than real-world depreciation of assets, so we exclude that as well. Note: But don’t completely discount depreciation of assets! Remove depreciation, but then look at expected capital expenditures (“CapEx”) so you know you have the cash flow in the future to buy needed assets.
DE (or SDE)
Discretionary Earnings (also called Seller’s Discretionary Earnings) is used for smaller companies (generally under $1 million in earnings) that are typically owned by the manager. In this case it can be tough to separate out what the owner/operator gets vs. the earnings of the company. So we add them together into one number. Another way of saying that is to “addback” one owner’s salary (in addition to the interest, depreciation, etc. mentioned above). Thus when you are looking at a business that has an SDE of, say, $200,000, you know that you have $200K to spend on living, taxes, interest and capital expenditures. For example, if you historically have been living on a $120K salary, then you can think of the business as making $80K above that, and that $80K is available to service debt, enhance your savings account, etc.
EBITDA is generally used to show an investor how much a company is earning. The investor does not actively run the company, and must pay a professional manager to do that for him. Thus the manager’s salary is included in the earnings calculation. It is not added back as in the SDE calculation. Simply put, EBITDA is a way for an investor to measure the return on investment he will receive should he purchase a company.
I should mention that advanced investors go further than EBITDA and use discounted free cash flow or discounted cash flow (DCF) analysis. EBITDA is not a true cash flow, and really what an investor wants to know is how much cash a business will generate in the future. A DCF model includes taxes, working capital, growth, CapEx and anything that impacts cash flow, and then discounts those future cash flows to a present value. DCF is pretty hard to do correctly, so it usually is only used for larger deals well above a few million in value.
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