Income, assets, and market are the three most popular approaches used to value a business. This article will focus on the different types of income used within the income methodology. Under the income approach, businesses are valued based on the profit the business generates. Buyers are more concerned with the amount of income that would be available to them if they acquired the company. Net ordinary income, reported in the profit and loss statements for tax purposes, does not represent the true earnings of the business based on non-cash, discretionary, non-recurring items spent by the owner of the business. 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 and loss statements must be restated during the valuation process to obtain SDE or EBITDA. Consolidation standardizes (or normalizes) business earnings through the exclusion of discretionary, non-recurring and variable items, allowing for an accurate and objective comparison between two or more businesses. The value of the business is then calculated by applying a multiple, consistent with the industry and a weighting of the factors that affect the business, to the amount of SDE or EBITDA.
Seller Discretionary Earnings (SDE):
Seller’s discretionary earnings (also known as discretionary earnings) are generally used for businesses with less than $1 million in adjusted earnings. These businesses generally have the owner operating and receiving a salary through the company. With these small businesses, it is important to determine what the ‘owner’s profit’ is compared to the ‘profit’ of the business. This is achieved through a series of P&L adjustments called ‘add-backs’ that are made to pre-tax trading earnings. In certain circumstances, there are negative surcharges, such as in the case of a business that owns the building where the owner pays himself below-market rent or a family employee performing a critical business function is paid below-market wages. From the market. In both cases, an adjustment is made to normalize the expense to fair market value.
The most common adjustments in the recasting process are the following:
• Add the total compensation of an owner
– Payroll taxes
– 401K / Retirement Contributions
– Benefits (Club memberships, etc.)
• Add non-cash expenses
• Additional interest expense
• Add discretionary expenses (not necessary in the operation of the business)
– Owner vehicles
– Travel and entertainment
– Non-Essential Phones
• Add non-recurring expenses
– Attorney fees (for example, related to the sale of businesses)
• Adjust rent/lease to FMV
Earnings before interest taxes depreciation amortization (EBITDA):
Larger companies, typically with adjusted revenues greater than $1 million, use EBITDA to define company earnings. In most cases, the owner/investor does not actively direct the operations of the business 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 used to determine profitability and make comparisons between companies and industries because it removes the effects of accounting and financial decisions. A simple way to determine EBITDA is to subtract the SDE owner’s compensation and profits. While the EBITDA number will be lower than SDE, the multiple used in the valuation is usually higher, often 2-2.5 times the SDE multiple. Therefore, as one would expect, the market value of the same business calculated using either method should be similar. If not, a determination of why and which (or which other method(s)) must be made.