How to evaluate SDE vs. EBIT for a target's valuation?

February 06, 2023

by a searcher from University of Applied Sciences in Hamburg, Deutschland

Hello searcher community,
I know the technical differences between a companies earnings (EBIT et al.) and seller discretionary earnings (SDE). However, I sometimes find myself trapped in a mental loop when evaluating the company based on comparable multiples. An example: Let's say I am looking at a company which earns $250k in (non-adjusted) EBIT which includes the owner's CEO salary of $500k as cost, so the SDE is $750k. If the comparable multiple for this company would be 4x I would land at $3m EV with the SDE but only $1m EV with the EBIT. Pretty vast range... Could it be an approach to "normalize" the CEO salary to a competitive market rate, say $250k instead of $500k and then work with this as an adjusted EBIT x4 = $2M valuation? Also, does it matter if the owner only works 20h/week in the business, would you only factor in half an executive's salary? My idea definitely is to find a company which I could serve as a full time leader but certainly I do not want to buy myself a job and pay a multiple on my future salary in the company if a replacement's salary would usually be adjusted for. Would love to hear your philosophies on this question.

Reply by a professional
from University of Pennsylvania in Denver, CO, USA

It's a great problem you've identified - and for the reasons of purchase multiple you reference above, I'd recommend using TEV / PF Adj. EBITDA as a single metric to evaluate any purchase.. When you are trying to estimate the adjusted EBITDA, I would also subtract the seller's salary (if they will no longer be active) and add your expected salary.

Your #1 goal should be determining a valuation that won't meaningfully differ from the valuation at which you sell the business. Adjusting for your salary will help you create a fair comparison for how someone else would value your business after you buy it. TEV / adj. EBITDA is the most common valuation method used (for estimating exit valuation, you don't know what pro forma adjustments would be made).

When you hear someone say "pro forma adjusted EBITDA" here's how I'd unpack that:
- EBITDA: earnings before interest, taxes, depreciation and amortization - if you're acquiring an LLC that has no debt and passes through taxes, SDE is usually the same as EBIT. D&A can be business-dependent, but for services businesses it's usually pretty minimal
- The "adjustments" to get adjusted EBITDA are for one-time items that occurred recently but which you do not expect to recur going forward (e.g. if last year's earnings were artificially low due to a roof leak at a facility that needed repairs)
- the "pro forma" part means additional adjustments to look at how the business would have performed if you had been the owner over the past year (e.g. add your salary, add the cost of any expected accounting system upgrades, subtract the salary of any outgoing personnel)

My business does lots of advisory work will searchers so also happy to help more if helpful! (https://www.tryprophet.com/)

Reply by an intermediary
from Boise State University in 800 W Main St, Boise, ID 83702, USA

Hi Stefan, I suggest that you stop thinking about multiples and what "should be" the right one. The first step is to normalize the cash flow by making any adjustments to expenses including owner salary. For a valuation, the owner salary is based on the market and the industry it operates in, not what you'd pay yourself or what the current owner is receiving. That is why it is called "normalizing". Once you have a normalized cash flow, then calculate the EBITDA and/or SDE. EBTIDA multiples are larger than SDE multiples. However, both will lead to the same answer. The question you really should be asking is, how much cash flow does the company generate and how does that look to you? A multiple refers to the market approach to value meaning what did someone pay for another similar company. A multiple is another way of saying "what is the cost of capital required to address the business risk of this potential acquisition?" While it may be interesting to compare, it may have nothing to do with the business you're looking at.. And keep in mind EBITDA and SDE are NOT cash flow. Here is a link to an article I wrote about this topic that may help: https://www.bizbuysell.com/learning-center/article/cash-flow-sde-ebitda-what-business-buyers-should-use-to-decide-what-to-pay/

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