Valuating a Business: SDE or EBITDA

The difference between SDE & EBITDA

SDE and EBITDA are both financial metrics used to assess the profitability of a company, but they focus on different aspects of a company’s financial performance.

SDE stands for “Seller’s Discretionary Earnings.” It is a measure of a company’s earnings that is calculated by adding up the net income, owner’s salary, and other non-cash expenses such as depreciation, amortization, and interest expense. SDE is often used to value small businesses or to determine how much income a business generates for its owner. SDE considers the cash flow available to the owner after all the business expenses have been paid.

EBITDA stands for “Earnings Before Interest, Taxes, Depreciation, and Amortization.” It is a measure of a company’s profitability that shows how much earnings the company generates before accounting for certain expenses. EBITDA is often used in financial analysis to compare the profitability of different companies, as it eliminates the impact of different financing and accounting strategies. EBITDA does not include interest expenses, taxes, depreciation, and amortization, which are considered non-operating expenses.

In summary, SDE is a measure of the cash flow available to the owner of a business, while EBITDA is a measure of a company’s operating profitability. SDE includes owner’s salary and other non-cash expenses, while EBITDA does not include interest expenses, taxes, depreciation, and amortization.

How to calculate the SDE

To calculate the SDE you need to start with the company’s net income and add back certain expenses that are not essential to the ongoing operations of the business but may be necessary for the current owner to maintain the current level of earnings.

Here’s the formula to calculate SDE:

SDE = Net Income + Owner’s Salary + Depreciation and Amortization + Interest Expense + Non-Recurring Expenses + Other Non-Essential Expenses

Here’s a breakdown of each component:

By adding up these components, you can calculate the SDE, which provides a measure of the cash flow available to the owner after all business expenses have been paid. This metric is often used to value small businesses or to determine how much income a business generates for its owner.

How to calculate EBITDA

EBITDA is calculated by taking a company’s earnings before interest, taxes, depreciation, and amortization. The formula for calculating EBITDA is as follows:

EBITDA = Net Income + Interest Expense + Tax Expense + Depreciation + Amortization

Here’s a breakdown of each component:

By adding up these components, you can calculate a company’s EBITDA. This metric is often used by investors, analysts, and lenders to evaluate a company’s financial performance, as it provides a measure of its operating profitability before accounting for certain expenses.

When to apply SDE

For main street businesses, it is typically more appropriate to use SDE rather than EBITDA for valuation purposes. The reason for this is that SDE considers the owner’s salary and other non-cash expenses that are unique to small businesses, which may not be captured by EBITDA. This is important because small businesses often have a significant owner involvement and the owner’s salary is a major expense that affects the profitability of the businesses.

In addition, main street businesses may have different financing and accounting strategies than larger businesses, which can impact their EBITDA calculations. SDE, on the other hand, provides a more accurate representation of the cash flow available to the owner after all business expenses have been paid.

To sum up, SDE is a more appropriate valuation metric for small businesses because it reflects the unique characteristics of these businesses and provides a more accurate picture of their financial performance.

When to apply EBITDA

EBITDA is often used to value mid-market businesses for several reasons:

Comparable Metrics: EBITDA is a widely accepted metric for valuation and is often used as a benchmark in the market. This means that it is easier to compare the valuation of one business to others in the same industry or market.

Focus on Operating Performance: EBITDA focuses on the operating performance of the business by excluding non-operating expenses like interest, taxes, depreciation, and amortization. This provides a clearer picture of the business’s operating profitability, which is important for investors and potential buyers.

Flexibility: EBITDA provides flexibility in the valuation process as it allows for adjustments to be made for one-time or non-recurring expenses that may not reflect the ongoing operating performance of the business. This flexibility allows for a more accurate valuation of the business.

Investor Preference: Many investors prefer using EBITDA to value mid-market businesses because it allows for easier comparison to other businesses and is seen as a more objective metric.

In conclusion, EBITDA is a more appropriate valuation metric for mid-market businesses because it provides a clearer picture of the operating performance of the business, is widely accepted in the market, and allows for flexibility in the valuation process.