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Understanding Seller’s Discretionary Earnings

Updated: Jan 14

What is Seller's Discretionary Earnings (SDE)?

Seller's Discretionary Earnings, also known as Seller's Discretionary Cash Flow (SDCF) or Owner's Discretionary Profit, represents the total benefits enjoyed by a business owner. It reflects the earnings available to the owner after accounting for various non-operational and discretionary expenses. Seller's Discretionary Earnings (SDE) is a crucial financial metric used in business valuation, particularly for small and medium-sized businesses. SDE provides insights into the potential profitability and financial performance of a business.

Calculating SDE:

SDE=Net Profit + Owners' Salary and Benefits + Non−recurring Expenses + Non−operating Income and Expenses + Depreciation and Amortization + Interest

Components of SDE:

  1. Net Profit or Net Income:

  • The core profitability of the business, calculated by subtracting all operating expenses from total revenue.

  1. Owner's Salary and Benefits:

  • Includes the owner's compensation and benefits. This is crucial because small business owners often include their own salaries as an expense.

  1. Non-recurring Expenses:

  • One-time or irregular expenses that are not expected to recur in the future.

  1. Non-operating Income and Expenses:

  • Income or expenses unrelated to the core business operations, such as investment income or losses.

  1. Depreciation and Amortization:

  • Non-cash expenses related to the wear and tear of assets over time.

  1. Interest:

  • Interest expenses are added back since they are a financing cost and not reflective of the business's operational profitability.

Importance of SDE in Business Valuation:

  1. Reflects True Earnings:

  • SDE provides a more accurate picture of a business's true earnings by accounting for discretionary expenses and owner-related perks.

  1. Comparable Metric:

  • SDE allows for easier comparison of the financial performance of different businesses, especially in industries where owner involvement and discretionary expenses vary.

  1. Valuation Multiplier:

  • Business valuation often involves applying a multiplier to the SDE to determine the business's overall value. The multiplier is influenced by factors such as Comparable Sales, Market Conditions, Risk Profile, Growth Prospects, Business Size and Market Position, and Industry Standards.

    • Business Value = SDE × Valuation Multiplier

  1. Assists Potential Buyers:

  • For potential buyers, understanding SDE is crucial in evaluating the financial health of the business and estimating the return on investment.

  1. Use in Seller Financing:

  • SDE is often used in seller financing arrangements where the seller provides a loan to the buyer. It helps establish the business's ability to generate enough cash flow to cover debt payments.

See Also:

Understanding Seller’s Discretionary Earnings
Understanding Seller’s Discretionary Earnings