EBITDA and SDE are the two drivers behind valuing a business under the Direct Market Data Methodology, using a company's profitability and cash flow while factoring in market-based multiples that apply to these figures.
What is EBITDA and SDE?
EBITDA is an acronym for Earnings Before Interest, Taxes, Depreciation, and Amortization, while SDE stands for Sellers Discretionary Earnings.
EBITDA looks at a company's reported net income and adds back the components listed above. SDE adds back variables such as the owner's salary, non-cash and one-time expenses, interest on debt and non-operating expenses.
Other adjustments may be made to these figures based on the particular business and how the owners account for certain expenses and compensation. Under this approach, a market-based multiple is then applied to these calculations to estimate value.
It is uncommon for an appraiser to estimate value using both EBITDA and SDE, so which of these should be relied upon when valuing a business? This is typically determined based on the size of the company and its net income level. The other consideration relates to the involvement of and reliance on the owner to run the operation.
For example, suppose a small business has a net income under $1,000,000 annually and is heavily reliant on the owner's involvement. In that case, SDE should be the measure, given that owner compensation is a major component when adjusting profitability.
On the other hand, with larger companies with net incomes higher than $1,000,000 and the owner's role being less critical to running the business, EBITDA should be the focus. If the owner already has a management team in place, there is no need to rely on the owner's compensation as part of the earnings adjustment.
As a result, EBITDA will typically be less than SDE, and the multiples applied are higher than SDE, given that the prospective new owner will not have to work full-time to run the company successfully.
In summary, once the business appraiser understands the company's structure and net income history, they can make a sound decision about whether to rely on EBITDA or SDE when valuing your business.