Ebitda vs. SDE: What Are the Differences and When to Use Them?
If you are thinking about valuing a company, how would you go about it? If it’s a publicly traded company like Apple, you would just go to any finance website and check up on their share price and market capitalization. However, what if it’s a small company without such information?
Most investors or financial advisors will advise you to look at their financial statements or, more specifically, the Earnings Before Interest, Tax, Depreciation, and Amortization (EBITDA) or the Seller’s Discretionary Earnings (SDE) to value the company. These financial metrics are similar but differ in terms of usage depending on the nature of the business.
Let this article show you the difference between SDE and EBITDA and how to use them in different contexts!
What is EBITDA?
In a nutshell, EBITDA is the company's earnings or profit before paying for interest on debt and tax without taking into account depreciation and amortization. EBITDA can be simplified in the following equation:
EBITDA = Net Profit + Interest + Tax + Depreciation + Amortisation
What is SDE?
SDE, on the other hand, is similar to EBITDA but includes any salary or benefits attributable to the company's owner. SDE can be simplified in the following equation:
SDE = EBITDA + Salary + Owner Benefits
Owner Benefits = Insurance + Vehicle Payments + Other Personal Expenses
What do they look like in a financial statement?
EBITDA vs. SDE
To put it simply, EBITDA subtracts the salary and benefits paid to the managers or owners in the financial statement, while SDE doesn’t. If the company is a small business with the owner being highly involved with few employees, valuation using EBITDA might not give the best valuation of the company to a buyer or seller. SDE, on the other hand, is ideal in this context.
Why should you care about EBITDA or SDE?
EBITDA is ideal for an investor or owner to use when the company is sufficiently big with a steady revenue stream and doesn’t require a deep involvement by the owner or shareholder in the operations. In this case, the owner and shareholder focus on the company's overall strategy and leave the implementation and operation to managers hired specifically for those roles. Company profits are more important than the salary and benefits they get, as they focus more on obtaining dividends.
However, if you are the owner of a small company, you are most likely to be highly involved in the implementation and operations of the company, taking on the role of manager also. In that case, salaries and benefits attributable to the owner matter, similar in importance to the company profits. Hence, the owner’s total profit from owning and managing the company should include both the company profits and salaries and benefits.
This will have important implications for you as an owner looking to sell and an investor looking to acquire the company from another person.
How are valuations normally done for a company?
Before that, let us just generally go through how companies' valuations are done. The most common one is using a price-earnings ratio, where the company's share price is obtained by multiplying the earnings/profits per share by a multiple. The multiple is normally between 10 times to 16 times. Any valuations below 10 times indicate that investors might be negative on the company’s future performance, and valuations above 16 times indicate that investors are bullish on the company. However, this method is normally used for companies that are already well-established and publicly traded in the market.
Similar to the price-earnings ratio, you can also apply a multiple to EBITDA and SDE to obtain the company's valuation. For EBITDA, that multiple is around 3-8 times; for SDE, that multiple is around 1-3 times. However, different industries will have different valuation multiples. Generally, the profit multiple of your company will be in line with other similar companies in your industry. If investors are bullish on the industry, expect higher valuations for your company and industry and vice versa. To get a higher valuation multiple compared to your peers, your company needs to show that it has the extra edge (in terms of business efficiency or a strong market share).
Why SDE and not EBITDA?
For an owner highly involved in his or her own business, EBITDA is useful for gauging how well the business is operating, but not for valuations. This is because the owner doesn’t just profit from the company operations but also the salary and benefits attributable to him or her. Valuation done through EBITDA does not include salary and benefits to the owner, which could potentially reduce the company's valuation.
If the owner is using EBITDA and the SDE multiple of 1 times to 3 times to value his or her company, the owner is undervaluing the business and could be getting fewer profits or gains if the company is sold to another investor. Hence, the owner needs to use SDE, which is often higher than EBITDA.
You would be wondering, “why not just apply a higher multiple to EBITDA such as 4 -8 times to get a similar company valuation?” This will apply if the company is sufficiently large enough and EBITDA is quite high. For smaller companies with owners that are highly involved in the operations, EBITDA could be low and sometimes negative and potentially undervalue the company. By adding back salaries and benefits that went to the owner, the owner and investors could obtain a better view of the company’s performance and valuation.