As an investor, I am interested in local small businesses that have a history of success. How do we determine this? We calculate the purchase price of a business by looking at either EBITDA or SDE. What is EBITDA or SDE you ask? Let's find out together...
Here is a ChatGPT crash course on EBITDA vs. SDE:
ME:
I am purchasing a business and I need a crash course in SDE vs. Ebitda to calculate the estimated sales price multiple of the business. Please act like a Business professor and give me the best knowledge and information to understand and calculate SDE vs. EBITDA.
CHATGPT 4:
Certainly! Let's dive into the concepts of SDE (Seller's Discretionary Earnings) and EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) and understand their significance in the context of business valuation.
1. EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization)
Definition: EBITDA is a measure of a company's operating performance. Essentially, it's a way to evaluate a company's performance without having to factor in financing decisions, accounting decisions, or tax environments.
Formula:
Why it's used:
EBITDA provides a clearer picture of a company's profitability from its core operations, removing the effects of financing and accounting decisions.
It's a common metric used by investors and analysts to compare profitability between companies and industries because it eliminates the effects of financing and accounting decisions.
EBITDA is often used in valuation ratios and compared to enterprise value and revenue.
2. SDE (Seller's Discretionary Earnings)
Definition: SDE is an earnings metric used primarily for valuing small businesses. It represents the total pre-tax income that a business owner can derive from the business in one year.
Formula:
Why it's used:
SDE is particularly useful for small businesses where the owner's compensation may not reflect the market rate. It adjusts for the owner's salary and benefits.
It provides a clearer picture of the total benefits an owner gets from the business, which is crucial for potential buyers.
SDE is commonly used in the valuation of small businesses to determine an appropriate sales price.
SDE vs. EBITDA:
Size of Business: SDE is typically used for smaller businesses, while EBITDA is used for larger, more established companies.
Owner Compensation: SDE includes adjustments for the owner's salary and benefits to reflect the true earnings of the business. EBITDA does not.
Purpose: SDE is used to show the total benefits an owner can derive from a business, making it crucial for potential buyers of small businesses. EBITDA is used to analyze and compare profitability between companies and industries.
Calculating the Purchase Price Multiple of a Business:
The sales price multiple is a ratio used to determine the value of a business. It's calculated by dividing the sales price of the business by its earnings (either SDE or EBITDA, depending on the size and nature of the business).
Formula:
For example, if a business is listed for sale at $1 million and has an SDE of $250,000, the sales price multiple is 4. This means the business is priced at 4 times its annual earnings.
Conclusion:
When valuing a business, it's essential to understand the nature and size of the business to determine whether SDE or EBITDA is the appropriate metric to use. For small businesses, SDE provides a more comprehensive view of the earnings, while EBITDA is more suitable for larger companies. The sales price multiple gives potential buyers an idea of how the business is valued relative to its earnings.
Could it be that you want someone to work with you to calculate the purchase price of your business? If you would like me to consider your business for purchase... hit the "Let's Chat" button below to connect with me and my team.
- Kimberly
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