Business Valuation Blog | Understanding Buying / Selling a Company

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.

When you're trying to determine the financial condition of your business, there is a wide range of formulas and techniques available. One key measurement is calculating earnings before interest, taxes, depreciation, and amortization (EBITDA). What exactly is EBITDA? Here's an inside look at how this figure is calculated and utilized in measuring the financial status of a business:

A Breakdown of EBITDA

The components of EBITDA consist of:

• Earnings: This refers to net profit, or the total revenue of your company less expenses and overhead.
• Before: The earnings before additional deductions are considered.
• Interest: Interest represents the cost of any loans and similar financial instruments your business has on the books.
• Taxes: This typically refers to income taxes only.
• Depreciation: Depreciation represents how much capitalized value you deduct for your fixed assets over a particular time period. It is typically determined using acceptable accounting standards such as the Modified Accelerated Cost Recovery System (MACRS) or through an updated valuation of your company’s tangible property (equipment and real estate).
• Amortization: Amortization is the reduction of business debt, such as loans and alternate types of financing over a given period.

As a general rule, EBITDA is a measurement to determine a company's profitability, or cash flow, however, it may not fully represent cash earnings. EBITDA considers a wide range of factors that come into play with business finances. It is not a universally accepted accounting measurement, and, therefore, has some flexibility with how it is calculated and measured.

From an application perspective, it is used by banks and financial services companies to estimate debt servicing levels. It is also commonly used to compare similar businesses within an industry or market and as a tool to preliminarily estimate a company’s current value using multiples of EBITDA.

A similar calculation that provides the same basic information is the earnings before income and taxes, or EBIT. The difference with this measurement is the exclusion of depreciation and amortization. When these variables are removed from the calculation, it represents the company's operating profit vs. overall cash flow.

With an understanding of how EBITDA is measured and utilized, you can gain a better understanding of how your company is viewed in the industry and its overall financial health. It is always optimal to have a more detailed independent measurement of value completed for your company, especially if you plan to sell, expand or refinance debt. A certified business appraisal will provide you with the overall value of your company, as well as information on the market, industry, competition, and the strengths and weaknesses of your company.