Understanding Small Business Valuation: The SDE Method

?When it comes to valuing small businesses, there are several methods available, each with its own strengths and limitations. One widely used approach is the Seller's Discretionary Earnings (SDE) method, which considers various factors to determine the value of a business. By applying a multiplier to the SDE, those looking to buy a business can estimate a fair price for acquiring the business and those looking to sell a business can get a good understanding of what they can expect for their business. In this article, we'll explore the SDE method and how it can be used to value a small business.

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SDE, in simple terms, refers to a company's annual income before tax, noncash expenses such as depreciation, nonoperating expenses like interest on loans, one-time expenses, and the owner's salary. It provides a comprehensive picture of the company's profitability by considering various financial elements.

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You will see the term EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) used frequently and this can be thought of as the dollar value that the business generates after paying a manager to run the business instead of the owner working in the business. If you had a SDE of $550,000 and you discovered the market rate for a manager would be $100,000, you would calculate an EBITDA of $450,000. This an oversimplification but attempts to convey the basics. For this article, we will stick with SDE going forward.

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One of the significant advantages of using SDE for valuation is that it disregards expenses that don't impact cash flow, are unusual or nonrecurring, or don't significantly affect the main course of business operations. This approach prevents artificially deflating a company's perceived profitability and allows potential buyers to evaluate the business based on its true earning potential.

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To determine the value of a small business using the SDE method, a multiplier is applied to the SDE figure. For many businesses, the multiplier typically falls within the range of 2 to 3.5, depending on several factors. These factors may include market risk, the company's future profitability prospects, and industry or geographical standards.

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Let's consider a practical example to illustrate how the SDE method works. Suppose you are interested in purchasing a distribution company located in a bustling metropolitan area. Upon reviewing the income statement, you discover that the owner reports annual revenues of $2,500,000 with cost of goods and operating expenses of $2,00,000, resulting in an operating income of $500,000.

Digging deeper into the company's general ledger, which provides a detailed record of all transactions, you learn that the owner's salary amounts to $350,000 per year, and the company remodeled the warehouse and office last year, incurring a cost of $150,000. The company also brought in a consulting firm to improved efficiencies which has completed its consulting and cost $50,000.

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To calculate the SDE, we add the operating income, owner's salary, and noncash expenses (in this case, the cost of the remodeled warehouse and office last year). In this scenario, the SDE would be $350,000 + $150,000 + $50,000, amounting to $550,000.

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To determine the business's value, we apply a multiplier to the SDE figure. For this example, let's assume a multiplier of 2.75, which falls within the reference range. Let’s imagine the 2.75 was derived from looking at 20 similar businesses that had sold; the lowest sold for 2.0 times SDE and the highest was 3.5 times SDE, but the 2.75 was right in the middle of the range.

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Multiplying $550,000 by 2.75 results in a valuation of $1,512,500. Note this is a simplification of the valuation process to give an illustration of what is involved.

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It's important to note that the multiplier used in the SDE method can vary depending on the specific circumstances of the business being evaluated. Factors such as industry conditions, market demand, and growth potential may influence the multiplier applied. Therefore, it's crucial to conduct thorough research and seek expert advice to determine an appropriate multiplier for a given business.

While the SDE method provides a useful framework for small business valuation, it should not be considered the sole determinant of a business's worth. Other factors, such as market comparables, asset valuation, and future growth prospects, should also be taken into account. Ultimately, those looking to buy a business and those looking to sell a business will greatly benefit by engaging in careful analysis. This will significantly help when negotiating to arrive at a fair and mutually beneficial price.

In conclusion, the SDE method offers a comprehensive approach to small business valuation by considering the owner's salary, noncash and nonoperating expenses, and one-time costs. By multiplying the SDE figure by an appropriate multiplier, buyers can estimate the fair value of a business. However, it's important to remember that the SDE method is just one tool among many and should be used in conjunction with other valuation techniques to arrive at an accurate assessment.