When valuing a privately-owned business, business appraisers regularly use a financial performance measure knows as Seller’s Discretionary Earnings, or SDE. This measure is also known by several other names, including Adjusted Cash Flow, Seller’s Discretionary Cash Flow, and Owner’s Cash Flow, among others. With the discretionary earnings figure we seek to capture the full economic benefit, before taxes, available to a full-time owner working in the target business on a full-time basis.
According to the International Business Brokers Association (IBBA), discretionary earnings are defined as a company’s earnings prior to the following items:
- Income taxes
- Non-operating income and expenses
- Nonrecurring income and expenses
- Noncash charges (depreciation, amortization, goodwill impairment)
- Interest income or expense
- Owner’s total compensation for services that could be provided by an owner/manager
Owner’s total compensation includes all payment and financial benefits enjoyed by the owner. It generally includes items such as salary (including the associated payroll tax), bonuses, insurance expense, auto-related expenses, travel expenses, in addition to other owner perquisites and discretionary expenses identified by the analyst.
Once a business appraiser has identified the target company’s SDE, he or she will generally apply an earnings multiple to it in order to establish an SDE-based measure of company value. This is effectively the same process that a stock analyst may go through when determining the value of a publicly traded stock: they would probably use an earnings stream like net income, EBIT, or EBITDA and then apply a multiple to that income stream based on the analysis they’ve performed.
Related post: Why Use Seller’s Discretionary Earnings to Value a Business?
