The Seller’s Discretionary Earnings Method (Part 1 of 2)

We receive quite a few inquiries on the Seller’s Discretionary Earnings (SDE) method of pricing a business. For those who want an official definition, following is one from the International Business Brokers Association and a further explanation from Business Reference Guide.

The SDE method of pricing a business actually came into its own in the late 70s – early 80s. Similar methods had been used, but this method came in the 70s and 80s. It was originally called Seller’s Discretionary Cash (SDC), which is what it really is. The SDE came later as it sounded a bit more serious. Bill Womack, an industry veteran, along with Connie Womack were the instructors for the VR Business Brokers training program and the SDC method was taught in that program. Jeff Jones and I wrote about this method in books we did for John Wiley and Sons. It is now an accepted method for valuing small businesses.

However, quite a few experts have said that revenue multiples are likely to be more reliable than earnings multiples when it comes to rules of thumb. The reason is that most multiples of earnings are based on add-backs to the earnings, which can be a judgment call, as can the multiple. Sales or revenues, they’re the same, are essentially a fixed figure. One might want to subtract sales taxes, if they have not been deducted, but the sales are the sales. The only judgment then is the percentage. When it is supplied by an expert, the percentage multiplier becomes much less of a judgment call.

Pricing methods such as multiples of SDE, EBIT and EBITDA all have two things in common; one must calculate SDE, EBIT and EBITDA and then calculate a multiple based on many factors relating to the business. Multiplying the two should then produce the rule of thumb for that business. Unfortunately, these methods are based on two figures that are calculated by the person attempting to arrive at a price, opinion of value or a value itself.

The second rule of thumb used in the Guide is a multiple of earnings. In small businesses, the multiple is used against what is termed Seller’s Discretionary Earnings (SDE). It is usually based on a multiple (generally between 0 and 4), and this number is then used as a multiple against the earnings of the business. Many of the entries also contain a multiple of EBIT and/or EBITDA.

Tomorrow’s posting will continue this article and include various terms used to express earnings.