Question on revenue and SDE discrepancy

searcher profile

February 10, 2022

by a searcher from Georgia State University in Boston, MA, USA

Looking at a company and the revenue hasn’t varied much in the past 3 years but the SDE has almost doubled. How is this possible? Should this effect the SDE multiple, currently they want a 3.5 SDE multiple based off the past year of high SDE but with that variance in SDE over the 3 years I feel that’s a pretty high.

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commentor profile
Reply by an investor
from University of Pennsylvania in Charlotte, NC, USA
All good comments above, and all pointing to the need to do a deep dive into the company's financials along with evaluation of material changes in the business model and qualitative analysis of the company's industry dynamics, competitive environment, etc.If accounting and financial analysis is not your strength, it could make sense to draw upon an outside resource to assist.if you're having trouble getting comfortable with the numbers, I would expect your investors and debt financing sources would be similarly skeptical.As so many said, the question is how sustainable is the (seemingly) greatly improved performance.
I would add that you should be analyzing cash flow, not just the income statement.
But first, just ask the seller and/or broker hard questions and require supporting data from them.A reasonable seller would expect to have to explain the unusual margin expansion, including, critically, a discussion of how sustainable it is.Has seller provided a projection along with discussion and analysis of same?If they cannot provide a satisfactory explanation that is supported by verifiable information or if they seem reluctant, evasive or offended by your standard due diligence inquiries, it's obviously a big red flag.
It's impossible to discuss an appropriate valuation until you're further down the road with your diligence but good luck with pursuing this opportunity.
commentor profile
Reply by an intermediary
from Arizona State University in Long Beach, CA, USA
I agree that the first step is to ask the Seller/Broker to provide an explanation, along with a detail of all the add-backs.In addition, you should pay attention to the following factors:
- Was there any reduction in staff?It's possible that they became more efficient. Was the staff member a family member? If so, it's possible that a spouse who was taking a salary before stopped taking a salary, but may still be doing work for the business - In which case, you'll need to account for market value replacement salary
- Was there a significant cost reduction in inventory, or some other service that the company procures?- This seems unlikely in our high inflation environment, but depending on the business type, it's possible ... they may have negotiated a discount....or could've been getting ripped off by vendors in the past
- Have they reduced spending in maintenance/repairs/upgrades etc?It's possible that someone thinking of selling the business may be only spending the bare minimum, and there could be some deferred maintenance costs that a Buyer will incur in the near future.
- Did they move to a smaller location with lower rent?
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