Business Valuation Blog | Understanding Buying / Selling a Company

Seller’s Discretionary Earnings (SDE) is a measure of the total earnings available to an owner-operator of a business. It is commonly used when analyzing small, single-owner businesses and is an important consideration when determining business value.

SDE is essentially EBITDA (earnings before interest, taxes, depreciation, and amortization), plus the owner’s compensation and benefits, along with appropriate normalization adjustments.

SDE answers the question: “What is the normalized financial benefit generated by the business for a single owner-operator?”

Understanding SDE can help business owners and potential buyers evaluate the normalized earnings of a business and how those earnings relate to value.

How Is Seller’s Discretionary Earnings Calculated?

SDE is intended to reflect the normalized financial benefit available to a single owner-operator, including business earnings, owner compensation and benefits, and appropriate adjustments to reported earnings.

A simplified SDE calculation may look like this:

Pretax net income

+ Interest expense

+ Depreciation and amortization

+ Owner’s compensation and benefits

± Appropriate normalization adjustments

= Seller’s Discretionary Earnings

The actual calculation for any given business can be more complicated. Financial statements often require normalization adjustments to account for unusual, nonrecurring, personal, or non-operating income and expenses.

The important distinction is that an expense is not automatically an add-back to seller earnings simply because the business owner considers it discretionary. Adjustments should be reasonable, supportable, and appropriate for the valuation being performed.

What Expenses Can Be Added Back to SDE?

Potential SDE adjustments vary by business but may include:

Owner compensation and benefits

For a business operated by a single owner, the owner’s salary and payroll costs, health insurance, qualifying vehicle expenses, and other benefits may be considered when calculating SDE.

Nonrecurring expenses

A significant expense that is unusual and not expected to recur may warrant an adjustment. The appraiser should consider whether the expense is truly nonrecurring and whether a buyer would reasonably expect to incur the expense, or a similar expense, in the future.

Personal or discretionary expenses

Privately held businesses sometimes pay expenses that provide a personal benefit to the owner and are not necessary to the ongoing operation of the business. These expenses may be considered for adjustment when they can be identified and supported. In closely held businesses, personal and business expenses are frequently intermingled, which can make it more difficult to identify and support discretionary owner expenses.

Non-operating income and expenses

Income or expenses unrelated to the normal operations of the business may also require adjustment when developing normalized earnings.

Every business is different, and adjustments should be evaluated individually rather than simply added back based on a predetermined list.

What Is the Difference Between SDE and EBITDA?

Seller’s Discretionary Earnings and EBITDA are both measures used to analyze business earnings, but they are not the same.

EBITDA represents earnings before interest, taxes, depreciation, and amortization. SDE typically starts with EBITDA and goes one step further by also considering the compensation and benefits of the owner, along with appropriate discretionary and nonrecurring adjustments.

SDE is therefore commonly associated with smaller businesses in which the owner actively works in the company and controls their own compensation and many of the company’s financial decisions. EBITDA is more commonly used for larger businesses and businesses where management compensation is treated as an ongoing operating expense.

The appropriate earnings measure depends on the business, ownership structure, and purpose of the valuation.

How Does SDE Affect Business Value?

SDE is commonly used as an earnings measure when analyzing transactions involving small, owner-operated businesses. Market data may indicate relationships between the selling prices of comparable businesses and their SDE.

However, SDE alone does not determine the value of a business.

Two businesses with the same SDE can have significantly different values because of differences in growth, customer concentration, owner dependence, competition, management depth, recurring revenue, and other risk factors.

A business valuation considers the appropriate earnings of the company together with the risks and market factors associated with generating those earnings.

Why Are SDE Add-Backs Important?

Add-backs can have a significant effect on calculated SDE and, consequently, on an indication of value developed using an SDE multiple.

For this reason, potential adjustments should be carefully analyzed and supported. A claimed expense may be discretionary to the current owner but still represent a cost that a hypothetical buyer would need to incur.

For example, the compensation of one owner-operator is generally considered in calculating SDE. However, if multiple owners work in the business, compensation for additional owners may need to be replaced with the market cost of employees or managers needed to perform those functions.

The Bottom Line

Seller’s Discretionary Earnings can be a useful measure for understanding the earnings of a small, owner-operated business. However, determining SDE involves more than simply adding expenses back to reported profit.

A qualified business appraiser will analyze the company’s financial statements, identify appropriate normalization adjustments, and determine which earnings measure is appropriate for the valuation. SDE can be an important part of that analysis, but it is only one of the factors considered when determining the value of a business.

Common Questions

What does SDE mean in a business valuation?

SDE stands for Seller's Discretionary Earnings. It is an earnings measure commonly used for small, owner-operated businesses and generally reflects the normalized earnings available to one owner-operator, including that owner's compensation and benefits.

Is SDE the same as profit?

No. Reported profit reflects the income and expenses recorded by the business. SDE adjusts reported earnings for certain items such as owner compensation and benefits, interest, depreciation and amortization, and qualifying discretionary or nonrecurring expenses.

Are owner distributions added back when calculating SDE?

Generally, no. Owner distributions typically do not reduce reported business earnings and therefore are not added back when calculating SDE. Owner compensation that was recorded as an expense, however, may be added back when determining SDE.

Is SDE the same as EBITDA?

No. EBITDA excludes interest, taxes, depreciation, and amortization. SDE generally includes additional adjustments, most notably the compensation and benefits of one owner-operator.

Can all owner expenses be added back to SDE?

No. An expense should not be added back simply because it benefits the owner or is labeled discretionary. Adjustments should be supportable and should reflect the appropriate treatment of the expense for the valuation being performed.

Is a business worth a multiple of SDE?

SDE multiples are commonly observed in transactions involving smaller owner-operated businesses, but applying a multiple to SDE does not automatically determine the value of a business. The appropriate multiple and valuation method depend on the company, industry, risk factors, market evidence, and purpose of the valuation.

Like many professions, the appraisal industry is full of acronyms that only those well-versed in the lingo can identify at first glance. Here are a couple of abbreviated terms that will factor significantly in the overall valuation of your small business.

EBITDA: Earnings Before Interest, Taxes, Depreciation, and Amortization

Even the long version of this acronym is confusing to understand. Here is a short discussion of its meaning and purpose:

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 in business finances. It is considered a universally accepted appraisal measurement and is also used in accounting circles.

From an application perspective, it is used by banks and financial services companies to estimate debt servicing levels. It is also 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 developed from historic databases.

SDE: Seller’s Discretionary Earnings

Seller's Discretionary Earnings (SDE) is a calculation that considers the net profit of a business while adding back discretionary adjustments to show the entire financial benefit provided to an owner.

SDE is a common income measurement calculated when a business is changing hands. Financial data associated with this calculation include EBITDA, as well as other factors that impact a company's value as you engage in a buy/sell transaction.

If you're on the purchase or acquisition side, SDE provides you with the information needed to develop a reasonable estimate of your expected future return, as well as an understanding of realistic expectations for the continued growth of the business. From the seller’s viewpoint, SDE supports an optimal level of value during sale negotiations. SDE allows both buyers and sellers to make informed decisions while preparing to invest in or exit a small business.

In summary, these are only 2 of several acronyms commonly utilized in the business valuation industry. Our next blog will discuss other terminology that may be important to better understand when you decide to appraise a privately owned company.

When you're trying to figure out your company's finances, there are a wide range of formulas and techniques that are available. But which one will work for your company and how will the different options impact your bottom line? One option is looking at earnings before interest, taxes, depreciation and amortization (EBITDA). But exactly what is EBITDA? Here's a look at how this type of value is calculated, what it means to your company and how it can affect your bottom line.

What is EBITDA? How does it impact your company's finances?

So exactly how is EBITDA broken down? Let's take a look:

• Earnings: This refers to net profit, or the amount of money your company is bringing in minus expenses and overhead.
• Before: This one's as simple as it sounds - it's the earnings before everything else is taken away.
• Interest: Interest is typically the figure listed on your company's income statement. It represents the cost of interest on loans and similar financial instruments for that period.
• Taxes: Taxes are also taken from a company's income statement, making it easy to work them into the figure. This refers specifically to income taxes only.
• Depreciation: Depreciation refers to how much value an asset has lost over a particular time period. It may be determined using a depreciation table or schedule, or using an equipment valuation to determine change in value.
• Amortization: Amortization is the expense of a loan, typically in terms of the amount of the loan that has been paid over the year, representing a gain in an asset's value to the company and a lowering of debt.

In general, EBITDA is a great way to determine a company's profitability, but not necessarily its cash flow. This is because it does not actually represent cash earnings, but looks at a wide range of other factors that may come into play with a company's finances. Because it is not a generally accepted accounting principle measure, there is greater leniency with regards to what exactly is included in the statement. It was originally developed to determine a business' ability to service debt. As time rolled on, it became more common when industries had expensive assets that were used for long periods of time. Since that time, it's become a commonplace calculation in virtually every available industry, including the tech industry.

Another report that provides the same basic information is the earnings before income and taxes, or EBIT. The only difference between these two is whether the depreciation and amortization are included in the calculation. When they are excluded from the report, it doesn't mean that they're not being counted, because earnings in this situation refers instead to the company's operating profit.

What is EBITDA? Now that you have a better idea about how this income can be calculated, it's much easier to gain an understanding of how your company operates and its overall financial health. Another aspect of that understanding is the insights you can gain from a business valuation. Business valuations not only provide you with the value of your company, they also deliver information on the market, the industry, your competition and where your company is strong and where it is weak. Why not look at having one performed to see where your company can go from here?

When you're trying to get a grasp on the world of business appraisals, one term that is often tossed around is valuation multiples. In general, it involves business valuations based on the value of another business, either by similar size and market share or by income, which is then adjusted for any differences between the two businesses. But what about valuation multiples we hear about in the news for different businesses? What makes these businesses gain or lose value and how can you apply that information and insight into your own business? Here are a few real-world examples, courtesy of Market Realist, of how companies' valuation multiples actually work.

How do Valuation Multiples Work in the Real World?

Fiat Chrysler Automobiles

There are a number of different valuation multiples used in the automotive industry, but one that stands out with Fiat Chrysler is EV-to-EBITDA, or enterprise value to earnings before interest, tax, depreciation and amortization. Recent figures have shown it to be approximately 1.3x, which is half that of Ford's 2.6x and GM's 2.5x. Chrysler's figures are also lower in price to earnings and net profitability. Why? Some of it is related to perceived loss of value in their products, but the main factors include their progress on the company's debt reduction plan, expanding margins consistently and trends in domestic car sales.

Home Depot

Because Home Depot has high earnings visibility, analyzing the price to earnings valuation multiple is one of the easiest ways to look at how this company competes. Even though the housing market is still recovering, the recent slowdown in the economy and uncertainty about changes in the interest rate have lowered the company's multiple from 20.4x prior to announcing its earnings to 18.4x. At the same time, investors are still confident in the company's ability to perform, with even its lowered multiple significantly outperforming competitor Lowe's 15.6x.

McDonald's Restaurants

After McDonald's reported gains in the prior quarter, the company's multiples grew from 18.6x to 18.8x. Though this seems like a small change, it can represent millions of dollars of value that was quickly added to a company that is already mature and does not have as much room for growth as younger competitors. In other words, because McDonald's has already grown through so much of the market, its ability to grow is limited, but their value can still improve based on improved earnings.

Time Warner Media

Time Warner has a price to earnings multiple that is second only to Disney's numbers, and an EV-to-EBITDA multiple that is the highest among the industry giants. But what is their advantage that keeps the company with the high numbers? The company has continued developing original programs, is looking at a new approach to content licensing strategies in overseas markets and has made active gains in promoting its digital platform viewer numbers. These innovations have allowed the industry giant to expand even in a tight market.

As you can see, valuation multiples are a tool used to determine the valuation of a company across many industries and specialties. By knowing how they interact with real work situations, you can get a better grasp of what events will impact your business' overall value.

And of course things change quickly...so by the time you are reading this the company's earnings and possibly the earnings have changed!