Income, Asset, and Market are the three of the more popular approaches used to value a business. This article will focus on the different types of earnings used within the income methodology. Under the income approach, businesses are valued based upon the earnings the company generates. Buyers are most concerned with the amount of income that would be available to them should they acquire the company. The net ordinary income, reported on the profit and loss statements for tax purposes, does not depict the true earnings of the company based on the non-cash, discretionary, & non-recurring items expensed by the business owner. Earnings are intentionally kept low to achieve the goal of mitigating income taxes. Therefore, to determine the true earning capacity of the business, the profit & loss statements need to be re-cast during the valuation process to derive either SDE or EBITDA. Re-casting standardizes (or normalizes) the business earnings through the exclusion of discretionary, non-recurring, and variable items, allowing an accurate and objective comparison to be made between two or more businesses. The business value is then calculated by applying a multiple, consistent with the industry and a weighting of the factors affecting the business, to the SDE or EBITDA amount.
Seller’s Discretionary Earnings (SDE):
Seller’s Discretionary Earnings (aka Discretionary Earnings) is generally utilized for businesses with under $1 million in adjusted earnings. These businesses typically have the owner operating and receiving a salary through the company. With these small businesses it is important to determine what the ‘owner benefit’ is as opposed to the ‘earnings’ of the business. This is accomplished through a series of P&L adjustments termed ‘add-backs’ that are made to the pre-tax business earnings. In certain circumstances, there are negative add-backs as in the case with a business that owns the building where the owner is paying himself a below market rent or a family employee performing a critical business function who is receiving a below market wage. In both of these cases, an adjustment is made to normalize the expense to a fair market value.
The most common adjustments in the re-casting process are as follows:
• Add-back one owner’s total compensation
– Payroll Taxes
– 401K / Retirement Contributions
– Perks (Club Memberships etc)
• Add-back non-cash expenses
• Add-back interest expense
• Add-back discretionary expenses (not necessary in the operation of business)
– Owner’s Vehicles
– Travel & Entertainment
– Non-Essential Telephones
• Add-back Non-recurring expenses
– Attorney fee’s (e.g. related to sale of business)
• Adjust Rent/Lease to FMV
Earnings Before Interest Taxes Depreciation Amortization (EBITDA):
Larger companies, generally with adjusted income in excess of $1 million, utilize EBITDA to define the earnings of the company. In most cases, the owner/investor does not actively direct the company operations and must pay a general manager to perform that function. Therefore, the EBITDA calculation will differ from SDE as it includes the manager’s compensation in the earnings calculation as an expense. EBITDA is a non-GAAP measure that is used to determine profitability and to make comparisons between businesses and sectors because it eliminates the effects of accounting and financing decisions. A simple way to determine EBITDA is to subtract the owner’s compensation and benefits from SDE. While the EBITDA number will be lower than SDE, the multiple used in the valuation is typically higher, often 2-2.5 times the SDE multiple. Thus, as one would expect the market value of the same business calculated using either method should be close to one another. If not, a determination as to why and which (or what other method(s)) must be undertaken.