The Role of “Seller’s Discretionary Earnings” in Business Valuation

Typically, “value” from a business valuation standpoint is based on a present value of expected “benefits” to the shareholder…. basic economics in terms of “risk” (cap/discount rate) vs “reward” (benefits or cash flow). Below is a crash course on how cash flow impacts business valuation.

Type of Statements Used. In some cases, “tax returns” are not in GAAP accounting and are not the most accurate reflection on the company’s performance. Relying on cash based accounting or tax returns with tax adjustments can severely over or under value a business; therefore, GAAP financial statements (or the most accurate available) should be used. This is even true when valuing business for SBA lending.

Calculation of Seller’s Discretionary Earnings (SDE). Smaller businesses are typically acquired based on a level of “SDE”, which is calculated as EBITDA + officer compensation + officer benefits & “perks” + or minus non-recurring or non-operating expenses/revenue. This calculation does not take into consideration a replacement salary. Some may say, “we won’t add these back because we’re assuming the potential buyer will also expense his/her auto, benefits, taxes, etc.” However, from a business valuation standpoint, any “benefit” to the owner that’s paid by the company should be included in discretionary earnings.

Properly Weighting Cash Flow. In determining “internal values” for brokers, a standard weighting is typically used. However, if using historical performance to gauge future performance, the weighting should be based on the most reasonable indicator of future performance. For instance, if the Company performed a one-time project in 2013 (or any year) that was not typical in a normal year, why would any weight be put on this year? My suggestion is to give a “confidence level” in % for each year analyzed and how likely the business will perform at that level. There is no right or wrong answer, it’s how you support your final weighting.

Cap / Discount Rates on SDE. Most “mainstream” or small businesses (non-professional practice) will sell in the 2.5x to 3.0x “discretionary” cash flow range. Therefore, cap rates (if inverted) would range from let’s say 30% to 40%. From this range, the analyst should increase or decrease the percentage based on marketability factors such as quality of financial statements (number of add-backs), customer/supplier risk, reliance upon management, growth/margins, pool of buyers, among other factors.

Putting it all together. As shown on the following page, we’ve shown you a straightforward approach to using discretionary earnings to estimate the value of a small business. There are cap / discount rates on EBITDA (and other financial variables); however, discretionary earnings multiples are prevalent and is typically an “apples to apples” comparison because replacement salary is not a consideration (and can be subjective). Our rule of thumb is focus on SDE where there is an owner/operator present and total SDE is below $500,000. For larger businesses where an investor could hire a CEO and/or total SDE approaches say $750,000 or higher, EBITDA multiples are primarily used.

There are multiple levels of “cash flow”; however, discretionary earnings are the most popular to “capitalize” for small businesses. Although some brokers typically focus on “EBITDA” (cash flow after using a replacement salary), next time try the calculation above. Feel free to contact us for “rules of thumb” or comparable sales.
Steven A. Mize, is the Managing Partner at GCF Valuation, Inc. and PeerComps, Inc. Steve is an accredited Senior Appraiser with an extensive background in the business valuation. Please feel free to contact him with questions on this article or with any other business valuation questions. This article appeared in the March 2017 Main Street News