In the world of private company valuation, business appraisers will often refer to and use multiples of Seller’s Discretionary Earnings, or SDE, when discussing or calculating firm value. The reason we use discretionary earnings, the reason the figure is so important to us, is because it tells us what the earnings power of the target firm is for the owner of that firm.
NOTE: click here for the definition of Seller’s Discretionary Earnings.
It is also important to note that:
- Business brokers frequently use multiples of discretionary earnings when involved in the buying and selling of small privately-held companies.
- Business buyers and sellers commonly use discretionary earnings as the financial measure with which to work when transacting.
- Banks that provide acquisition financing are familiar with discretionary earnings and often use them, or derivations of them, when defining lending parameters.
- Many of the information sources that report private company transaction data include multiples of discretionary earnings. These sources (Bizcomps, the Institute of Business Appraisers transaction database, Pratt’s Stats, and others) are commonly used in the “market approach” when seeking out comparable transactions.
Because the use of discretionary earnings is so common in the buying and selling of private businesses, its use must be given active consideration when performing a business appraisal. In the author’s opinion, it is the single most important earnings figure of any privately held firm: it provides important insight into the Subject company and an important point of comparison for market transaction data when appraising the target firm.
Related post: What are Seller’s Discretionary Earnings?