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What Should You Use When Deciding How Much to Pay for a Business Acquisition: Cash Flow, Earnings, SDE, or EBITDA?

Recently, a prospective buyer asked: "When I look at business sale opportunities, the business broker shows Cash Flow and then multiplies it by a multiplier to come up with the asking price. So, my question is, what is Cash Flow? Is it EBITDA or Discretionary Earnings?"

The buyer's question is valid. It is confusing to business buyers especially when the words "cash flow" and "earnings" are used interchangeably. In business-for-sale advertisements, business brokers talk about "cash flow" but it isn't really cash flow. It is normalized seller's discretionary earnings SDE (or in some cases normalized EBITDA).

What is Cash Flow?

Cash flow is neither EBITDA, Discretionary Earnings, nor net profit. Cash flow is the movement of cash into and out of a business. Without adequate cash flow, a business doesn't survive; just like us if we didn't have water, air, and food. A cash flow statement demonstrates a company's sources and uses of cash over a specific time period such as from one year to the next or from one month to the next.

Cash comes from business Operations (which is the core function of the company); cash from Investing (which means did its owners contribute equity to the business to cover its cash flow needs or did they distribute some to pay themselves); and cash from Financing, which indicates whether the company borrowed money (cash in) or paid it back (cash out).

Business Brokers use adjusted SDE or EBITDA as a proxy for "cash flow" when advertising businesses for sale. However, each situation is different and buyers need to analyze the details of that "cashflow" to determine what was included.

What Does SDE Mean?

SDE (Seller's Discretionary Earnings) is an acronym used primarily by business brokers to describe the available earnings of main-street-sized businesses. An easy way to think of it is: SDE equals EBITDA plus the normalized salary of one working owner.

SDE example:

What are "Discretionary Earnings"?

It refers to the "normalizing" of the company's Income Statement by adjusting and/or removing the non-recurring or personal or non-business-related expenses.

It also may mean adjusting rent to market rate because sometimes when a business owner owns the real estate and rents to himself, he may pay too much or too little rent. If the rent is too low, the business is overpriced. If too high, the business is undervalued. Normalizing also includes adjusting revenues or cost of goods sold, if necessary.

The purpose of making these normalizing adjustments is to reflect the company's true operating performance to determine the most probable selling price or valuation. Just like with EBITDA, SDE only considers the Income Statement and not the balance sheet. (Remember: EBITDA should also be after normalizing adjustments.)

SDE is Not Cash Flow

Rather, it is the amount of potential earnings available to the business owner based on the company's normalized earnings and owner salary. The same goes for EBITDA. Often with larger companies, an adjustment is made to reflect wages for a general manager to run the company if the owner did not work in the business or receive a market-rate wage.

However, the SDE earnings stream is a different from the EBITDA earnings stream and you can't really determine how much to offer for a particular business without first doing specific analysis. A multiple is the result of dividing a selling (or asking) price by an earnings stream. Thus, when the numerator and/or denominator change, the multiple changes. Multiples may be an indicator, but they are not a definitive answer to an offer amount.

What is EBITDA?

EBITDA refers to Earnings Before Interest Taxes Depreciation and Amortization. It's calculated by adding back interest, tax depreciation, and amortization expenses to net income. The building blocks of EBITDA are derived from the Income Statement (also known as the Profit & Loss Statement). The Income Statement tells only half of the story of a company's financial performance; the Balance Sheet tells the other half.

EBITDA example:

How are Multiples Used?

First of all, whenever the word "multiple" is used, the valuation method being discussed (or implied) is the Market Approach. What is the Market Approach? It is comparison of sold business data to the subject company that you may want to buy. There are several databases that track sold business data by industry code, location, revenue, EBTIDA, SDE, and other details.

Searchers, M&A professionals, and financial gurus talk about the rise and fall of EBITDA multiples in an industry and over time. This may sound funny but as a business broker and appraiser, I don't pay much attention to these discussions. It's assumed that a ratio derived from one company (or perhaps several companies using a median or average of the group) is an adequate method to determine the likely price of a particular company offered for sale. That may or may not be the case unless the company you are considering has median or average performance!

Why? Because I know that a multiple is a ratio resulting from dividing the sales price of a particular business by its "earnings". I've put quotes around the word "earnings" because one must know the components of those earnings to make sure that it is truly EBITDA and not something else such as net profit, SDE, free cash flow, etc. The integrity of the data gathering used to demonstrate the multiples is extremely important.

For example, when I'm pricing a business for sale, I select similar comparables based on revenue size, description, earnings, etc. of sold businesses within an industry using one or more of the available subscription databases. These databases make efforts to verify the input from the business brokers and M&A professionals that submit the data before publishing. Some are better than others.

Depending upon the database and particular comparables selected, the resulting multiples for my subject company vary. Why? Because, the selection of the comparable businesses sold affects the outcome! Therefore, I have never found broad brush multiples to be useful in determining the price of a particular business because each transaction is unique and the similarities to the subject company is unknown. My point is, don't get too hung up on industry multiple reports. To determine the" right" multiple (which is really another way of saying "right price") for the company you may want to buy, you'll need to dive into the financial performance details of that company.

When buying a business, you are really buying the future anticipated earnings of that particular company at some risk percentage (whether you realize it or not).Your decision is based on the past historical performance and perhaps some future projections, but your buying decision is based on the strong likelihood that you will continue to receive those earnings into the future. And you expect to get a reasonable return on your investment based on the risk being taken to purchase the business.

Keep in Mind: SDE and EBITDA Multiples are Not Interchangeable

Typically, an SDE multiple will be smaller than an EBITDA multiple. However, the outcome will generally give the same value estimate for a particular company. Just don't apply the EBITDA multiple to the SDE earnings and vice versa.

For smaller, owner-operator businesses, SDE generally is the most relevant earnings stream. For larger companies, with management teams, EBITDA may be more relevant.

Buyers Don't Buy Overpriced Businesses

Buyer expectations of the future affect the prices paid (i.e., the "multiples") on Main Street and lower-middle market M&A deals. In other words, a buyer won't purchase a business he believes is overpriced. If the seller wants to sell, then there is negotiation between the two to not only determine the price but the deal structure, which is just as important at price. The sales price (and its resulting multiple) reflects the outcome of that negotiation. Just because one company somewhere sold for a certain multiple does not necessarily mean that the business you are looking to buy will (or should) have a similar multiple.

To check the reasonableness of a purchase price, you can perform what is referred to as a "Buyer's Sanity Test". In other words, assume that you put 10% or 20% cash down on a purchase price and finance the rest over a ten-year term, common for SBA financing, at the current market interest rate. Are the adjusted earnings (either EBITDA or SDE) sufficient to repay the debt and leave an adequate margin? If not, then perhaps the price is too high or additional questions need to be asked about the business.

In the end, it doesn't matter what a business broker, appraiser, financial guru, or your smart friend says about multiples, the "market" determines the price. And "the market" consists of you as the buyer and the seller negotiating to buy and sell a particular business. So, does it make sense to buy a particular business at the offered price? Or should you offer a different amount?

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