SDE vs. EBITDA vs. Adjusted EBITDA
Leads to Multiples Confusion

SDE vs. EBITDA vs. Adjusted EBITDA Leads to Multiples Confusion

In the last issue (#6), we helped you understand How Small Businesses Are Valued Based on Seller's Discretionary Earnings (SDE). In this issue we will discuss how SDE vs. EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization) vs. Adjusted EBITDA leads to Multiples Confusion.

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SDE vs. EBITDA vs. Adjusted EBITDA Leads to Multiples Confusion

Many business owners have heard the term "multiple of earnings." In the stock market, the P/E (price/earnings) ratio refers to the market price per share divided by the earnings per share. For the S&P 500, as of April of 2012, the twelve-month trailing P/E was about 15. A great majority of individual public companies' P/E ratios fall in the range of 12 - 18. That's one way the term "multiples of earnings" might be used in conversation. It would be nice if small businesses could be sold for 12 - 18 times "earnings," but that's just not reality.

The multiple of SDE for many small businesses is in the 2 - 3 range

In the previous issue, Issue #6 - How Small Businesses Are Valued Based on Seller's Discretionary Earnings (SDE), we provided a chart with multiples of earnings based on SDE which showed a range from 1 - 4 times SDE. However, unless your business has SDE below $100,000 or above $500,000, the appropriate SDE multiple likely falls in the 2 - 3 range.

SDE vs. EBITDA vs. Adjusted EBITDA and the related multiples - it's all very confusing - so much so that we have three newsletter issues following this one devoted to the topic to increase your understanding.

"Earnings" must be defined

Yet many business owners have heard of small businesses selling for 5 or 6 times "earnings." The confusion regarding the "multiple" number being referred to in conversation arises from lack of clarity of the term "earnings." If you hear a small business sold for 5 - 6 times "earnings," rest assured the earnings are not based on SDE (Seller's Discretionary Earnings). In that case, the definition of earnings might have been EBITDA or Adjusted EBITDA.

SDE multiple = 3.0, EBITDA multiple = 6.2, Adjusted EBITDA multiple = 4.5

In the next newsletter, we'll provide an example of a business with $90,000 in taxable corporate income and show the computations that result in SDE of $300,000, EBITDA of $145,000 and Adjusted EBITDA of $200,000. It's the same business and the value is about $900,000 regardless of which measure (definition) of "earnings" is used. However, the multiple changes drastically. Under SDE the multiple is 3.0, under EBITDA the multiple is 6.2 and under Adjusted EBITDA the multiple is 4.5.

SDE calculation results in a larger number than EBITDA resulting in a smaller multiple

SDE accounts for owner's compensation (including owner perks) by adding it into "earnings" whereas EBITDA ignores owner's compensation. Therefore, the SDE computation results in a larger number, leading to a smaller multiple being used to value the company.

Let's review what was stated in the previous article: Public companies and middle market businesses are valued as a multiple of EBITDA - Earnings Before Interest, Taxes, Depreciation and Amortization (with no adjustment for owner's compensation). However, smaller businesses are valued as a multiple of Seller's Discretionary Earnings (SDE), which can be defined as EBITDA + Owner's Compensation. Therefore, Seller's Discretionary Earnings is typically the net income (or net loss) on the company tax return + interest expense + depreciation expense + amortization expense + the current owner's salary + owner perks.

Adjusted EBITDA accounts for "fair replacement value" of owner's compensation

Adjusted EBITDA attempts to adjust owner's compensation to its "fair replacement value" and the excess is included in the Adjusted EBITDA "earnings" number. For instance, if an owner collects $300,000 in salary from his corporation but it is determined that the "fair replacement value" of his services is $100,000, the Adjusted EBITDA computation would include $200,000 of "excess owner's compensation." In this example, considering only the owners' compensation, SDE would be $300,000, Adjusted EBITDA would be $200,000 and EBITDA would be $-0-.

SDE is appropriate for small businesses which are usually acquired by owner-operators

When valuing larger businesses, such as middle market businesses with valuations in excess of $5,000,000, the assumption is the buyer (or acquiring company) making the acquisition will have to pay someone (a CEO) to run the business. Therefore, the business is usually valued based on EBITDA or Adjusted EBITDA. However, buyers of smaller businesses are usually owner-operators who won't need to pay someone else to run the business .....