Sellers Discretionary Earnings (SDE)
SDE Definition
The recast income statement spreadsheet shows “Sellers Discretionary Cash Flow” (SDCF), (also known as Sellers Discretionary Earnings). This is the benchmark for earnings of owner/operator businesses used by business brokers, appraisers, buyers and sellers. Comparable sale data uses SDCF in the Price/Earnings Ratio (Sale price of business divided by the SDCF). Brokers recast income statements using standard methodology. This enables consistency in comparing small businesses and calculating values for buying and selling them.
Definition: The definition of SDCF is: pretax net profit plus non-cash expenses, discretionary expenses,
costs of financing, one-time expenses, and all compensation paid to a single owner/operator, less employee equivalent compensation to replace additional working owners and any known increases in fixed expenses.
Procedure:
1. Non-cash items are added back to pretax net profit because this cash is still available for the owner to spend.
2. Discretionary items are usually benefits to the owner, such as a leased luxury car that is used mainly for personal purposes, or items which could be eliminated without affecting the business otherwise, such as contributions to a charity or church.
3. Financing costs are added back because the earning power of the business is independent of the method an owner chooses to finance the business, so the seller’s debt payments are irrelevant to the buyer and the earning power of the business. Of course, a buyer should make a capitalization plan to see what his pretax, post-debt service cash flow will be. If a buyer is contemplating taking over some of the seller’s debts in acquiring the business, this does not effect the earning power or valuation of the business, but rather is just one of the forms of payment the buyer is using to pay for the acquisition of the business, much as in the purchase of real property where the buyer assumes the mortgage and gives the difference to the seller in cash.
4. One-time expenses are usually added back because the earning power of the business will not be reduced by those one-time items going forward. A good example of a one-time expense is the expense of moving a business to a new location.
5. One working owner: The standard for measuring small business earning power assumes a single working owner. If there are other owners or family members working in the business, their compensation must be “normalized” by adding back all their compensation then subtracting the cost for an unrelated employee to be paid at the going rate for the job he will have to do.
6. Known increases in fixed expenses: Since the theory behind the SDCF analysis is to estimate the earning power of the business going forward with the assumptions of one working owner, showing non-cash, discretionary and one-time expenses as earnings, it is only fair to reduce SDCF by known increases in fixed expenses going forward. A good example is a scheduled cost of living adjustment (COLA) in the premises rent.