SDE and EBITDA: Key Metrics for Business Evaluation
Valuing a business is a challenging task even for seasoned appraisers. The seller wants to sell their business at the highest price possible, while the buyer wants to buy at an attractive price and have a good return on their investment. This article will discuss the 2 key metrics normally used for business valuation: SDE and EBITDA.
What is SDE?
The Seller’s Discretionary Earnings or SDE measures the cash flow available to the business owner after all expenses and taxes are paid.
SDE is unique because it includes owner compensation, often neglected by other metrics, leaving small business owners feeling neglected.
To calculate SDE, here’s a basic formula:
SDE = Net income + Interest + Taxes + Depreciation and Amortisation + non-recurring income and expenses + non-operating income and expenses + Owner’s total compensation
Net income
Interest expense or income (the “I” in EBITDA)
Taxes (income taxes, the “T” in EBITDA)
Depreciation and amortisation (the “D” and “A” in EBITDA)
Non-recurring income and expenses
These are unusual or non-recurring expenses. For example, if the business incurred an unusual legal expense for one year, this would be added back into the SDE calculation.
Non-operating income and expenses
These are expenses that aren’t directly tied to the core operations of the business. For example, the business may be paying for an owner’s vehicle, personal travel expenses, or club membership, which aren’t directly related to the business. The cost of those expenses would be added back to calculate SDE.
Owner’s total compensation
The SDE calculation adds back the owner’s salary to account for the fact that the owner may choose to pay themselves more or less than what a typical manager would earn.
When To Use SDE
SDE is normally used with businesses that have less than $1 million in SDE.
What Is EBITDA?
EBITDA, or earnings before interest, taxes, depreciation, and amortisation, is an alternate measure of profitability to net income. By excluding depreciation and amortisation as well as taxes and debt payment costs, EBITDA attempts to represent the cash profit generated by the company's operations.
The respective EBITDA formulas are:
EBITDA = Net Income + Taxes + Interest Expense + Depreciation and amortisation
Or EBITDA = Operating Income + Depreciation and amortisation
When is EBITDA used?
EBITDA is normally used to value mid-sized businesses with greater than $1 million in EBITDA. This is because the majority of companies in the middle market are purchased by other companies that must hire and pay a manager or CEO to run them post-closing.
EBITDA vs. Adjusted EBITDA
The term EBITDA is used loosely and sometimes refers to “adjusted EBITDA.” Adjusted EBITDA includes additional adjustments that aren’t included in the calculation, similar to adjustments that are made to calculate SDE.
Some adjustments included in adjusted EBITDA, but not standard EBITDA include:
Non-operating income or expenses
Non-recurring income or expenses
Unrealised gains or losses
Owner perks
The Main Difference Between SDE and EBITDA
SDE (The Seller’s Discretionary Earnings) – The primary measure of cash flow used to value small businesses and includes the owner’s compensation as an adjustment.
EBITDA (Earnings before interest, taxes, depreciation, and amortisation) – The primary measure of cash flow used to value mid to large-sized businesses and does not include the owner’s salary as an adjustment.
Multiples of EBITDA are higher than multiples of SDE for the simple reason that a business that’s run by a manager should sell for more than one in which the owner is working full-time.
For the same price, would you rather buy a business in which you have to work 40 hours per week or one that’s run by a management team and doesn’t require any time commitment from you?
Criteria | Small Business | Middle-Market Business |
Risk | High | Low to Medium |
Recommended Multiples | 2.0-4.0 | 4.0-8.00 |
Earning | < $1 Million | $1 Million to $10+ Million |
Revenue | < $10 Million | $10 Million to $100+ Million |
Staff | Dependent on Owner | Strong Management Team |
Valuable Metrics | SDE | EBITDA |
Common Buyers | Individuals | Private Equity Groups or Companies |
Conclusion
When valuing a business with less than $1 million in earnings, use SDE, where the owner’s compensation is included. When valuing a business with more than $1 million in earnings, use EBITDA, where the owner’s compensation is excluded. Keep in mind that the two measures of cash flow concerning owner’s compensation represent the main difference between SDE and EBITDA.
The Next Step?
Hence, which valuation metrics apply to your business? If you have questions related to selling your company or considering selling your company in the future, please contact Ms Anna Tran, V.P Brookfield Aviation Finance via anna@brookfieldav.com for further support and discussion. For more details, please check our website at https://www.brookfieldaviationfinance.com/.
Our objective is to provide professional support for our clients to understand their goals in selling their company, provide insight from the market and guide them through the selling process. Let’s connect.
Reference: Investopedia, Morgan & Westfield
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