Pricing a Business: Using SDE and the Market 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, potential buyers can estimate a fair price for acquiring the business. You can use the SDE method to value a small business.

This is just to give you an idea of how the process works. If you are looking to buy a business or sell a business, enlist the services of a professional business valuation specialist and a business accountant.

What is SDE?

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 one working owner’s salary. It provides a comprehensive picture of the company’s profitability by considering various financial elements.

SDE Valuation Advantage

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.

SDE Method

To determine the value of a small business using the SDE method, a multiplier is applied to the SDE figure. 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.

Remember to apply the right multiple to the right factor. Some will use a multiple of EBITDA, NOI, Gross Revenues, and other options. These multiples differ significantly, and one needs to make sure they choose the correct multiple.

SDE Method Example

Here is an example to illustrate how the SDE method works. Suppose you are interested in purchasing a print shop. The income statement shows that the owner reports annual revenues of $1,000,000 and operating expenses of $750,000, resulting in an operating income of $250,000.

Digging deeper into the company’s general ledger, you learn that the owner’s salary amounts to $135,000 per year. You also see that the owner purchased a new printer last year for $15,000. Printers like this can last well over a decade when properly cared for and this business owner has not had to purchase another machine for over a decade.

To calculate the SDE, we add the operating income, owner’s salary, and noncash expenses (in this case, the cost of the printer) In this scenario, the SDE would be $250,000 + $135,000 + $15,000, amounting to $400,000.

To determine the business’s value, we apply a multiplier to the SDE. For this example, let’s assume a multiplier of 2.75, which falls within the reference range. Multiplying $400,000 by 2.75 results in a valuation of $1,100,000.

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, direction of sales, condition of equipment, customer concentration, and growth potential may influence the multiplier applied. Therefore, it’s crucial to thoroughly do your research to determine the most appropriate multiplier for a given business.

Other Factors to Consider

While this 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, buyers and sellers must engage in careful analysis and negotiation 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.

Lastly, remember that this is just to give you an idea of how the process works. If you are looking to buy a business or sell a business, enlist the services of a professional business valuation specialist and a business accountant.