BUSINESS VALUATION PART 1: CASH FLOW, EBITDA, SDE, NET PROFIT, NET BENEFIT TO OWNER AND MORE

The most important small business valuation methods are based on using a multiple of profits.  But there are so many different ways to describe the earnings of a business – how does the “Net Profit” differ from the “Net Benefit to Owner”, for example? What is the EBITDA? This video will explain the different terms and the context in which they are usually applied.

We’ll also discuss these concepts in a little more depth below.

The net profit of a business is simply its total revenues minus its total costs. It is the net profit before taxation that matters for small to medium businesses (for very large listed companies it is the profit after taxation that is more commonly used). The “Net Profit Before Tax” is often shortened to “Pre-Tax Earnings”, “Net Earnings” or just “Earnings”. They are all the same thing.

ADJUSTMENTS TO THE NET PROFIT

When selling a small business, the seller will typically want to demonstrate not only the net profit of the business, but the rest of the benefit they derive from it. This will include their salary and any other benefits they receive (car, mobile phone, healthcare etc). They want to show the total benefit they receive from the business, so instead of simply listing their company’s net profit, they list something else: the “Net Benefit to Owner”. In the US this is more commonly called the “Seller’s Discretionary Earnings” (SDE). This is supposed to represent the total benefit received by the owner. It is often called “Cash Flow” in the US (which can be confusing, since it has nothing to do with the accounting term referring to cash inflows and outflows). All of these terms mean the same thing: the total benefit derived from the business by the owner.

To maximise the apparent size of this benefit, sellers often adjust the accounts to remove things like depreciation (and where applicable, amortisation). Often they even deduct interest expenses, arguing that different owners will have different debt structures, so the interest payments are not relevant. The extent of the deductions can vary, but in many cases they will deduct unusual one-off expenses that they feel are not likely to be repeated and therefore should not reduce the profit figure. For example, the costs of repairing a roof after a bad storm might be deducted from the expenses (in other words “added-back” onto the profit). Each of these “Add-Backs” has the effect of making the net benefit figure appear higher, which the seller uses to justify a higher valuation. 

To be fair, negative adjustments are also made to the accounts. For example, if family members are working for free or for below market wages, this has to be accounted for and the corresponding costs added to the expenses (and therefore deducted from the profit). Similarly, if a business is not currently paying rent because it owns its own freehold property, the cost of rent at the market rate would be deducted from the profit if the new owner would not be expected to buy the freehold and would be required to rent.

All of these adjustments are negotiable, and buyers and sellers always have different views on them. Buyers may argue, for example, that depreciation is a reasonable expense, especially in a capital-intensive business. Equipment does, after all, depreciate over time.  Buyers will argue that since this cost will be expected to continue into the future, it should not be deducted from the expenses at all.  

Some buyers may argue that the owner’s salary and benefits should not be added back to the net profit, because the new owner does not intend to work in the business himself, and will need to employ someone to do the current owner’s job. While this is a fair argument, and can be negotiated with the seller, it is important to remember that the typical definition of the “Net Benefit to Owner” (or “SDE” / “Cash Flow” in the US), includes the owner’s salary and benefits.  So when small businesses are advertised for sale, the Net Benefit or SDE figure has been calculated to include the owner’s salary and benefits. 

In fact, in the US it is often considered acceptable for small businesses where the owner is truly not involved, to add on one manager’s salary on top of any salary and benefits taken by the owner, to calculate an SDE that allows for the fact that the new owner will be working in the business. By replacing this manager, he will therefore benefit from that extra salary himself. 

This highlights the assumption underlying these metrics: that a small business will be managed by its owner. This does not accurately reflect reality of course. Many small businesses are not managed by their owners, but have instead been systematised and are run by a management team. But it is important to note that this is the assumption that is used when these profit metrics are calculated.

The figure after all of these adjustments are made is the “Adjusted Net Profit”.  Sellers will call their version of this the “Net Benefit to Owner” (or “Seller’s Discretionary Earnings”, “SDE” or “Cash Flow” in the US).  Buyers will typically make their own adjustments and calculate their own version of the Adjusted Net Profit. The principle is the same: it is the net profit of the company, with adjustments to allow the figure to more closely reflect reality.

EBIT AND EBITDA

Two common metrics that are used to describe even the largest companies, EBIT and EBITDA are also sometimes used when valuing small businesses.

EBIT stands for Earnings Before Interest and Tax. Therefore this is simply the “Net Profit Before Tax” with interest added back on (since tax hasn’t been deducted yet).  It is useful to compare the profitability of companies after excluding interest payments, since similar companies can have quite different capital structures. As discussed above, small businesses owners will have different debt structures for the same company, so it can be argued that including interest payments would give a distorted view of the company's profitability. EBIT allows them to be excluded.

A more commonly used metric is EBITDA which stands for earnings before Earnings Before Interest, Tax, Depreciation and Amortisation. Commonly used to assess the net profitability of stocks by removing the impact of these accounting adjustments, this metric has been increasingly applied to small and medium-sized companies too.

WHICH TO USE

There is a general rule, followed more closely in the US, that for smaller businesses, SDE (or “Cash Flow”) is the profit metric of most interest and the one that would be displayed in the Information Memorandum or on an advertisement for the business for sale, whereas EBITDA would be used for larger businesses. This is due to the assumption discussed above, that for small businesses the owner will be actively involved and will take a salary from the business.

In the UK and most other markets there is more variation. Advertisements of businesses for sale quote the Net Profit from the accounts in some cases, the Adjusted Net Profit or Net Benefit to Owner in others, with varying inclusions and exclusions. 

Also, while the above descriptions represent the strict definitions of each term, in reality there is a lot of variation in their use. “Adjusted Net Profit” and “Cash Flow” in particular can vary greatly, depending on what is included and excluded. And even metrics like EBITDA, which have very clear definitions, are sometimes used by brokers and sellers as short-hand when they mean “Net Benefit to Owner” with the owner’s salary and benefits added in.

IMPACT ON VALUATION

While sellers like to make adjustments to the accounts to show that they are receiving a greater benefit from the business than the accounting Net Profit, in reality these adjustments do not have as great an impact on the valuation as one might think. As we will see in our upcoming videos, statistics of small businesses sales show that the valuation multiplier changes in accordance with the profit metric. So while a company’s “SDE” will be a larger number than its “EBITDA” figure according to strict definitions, the sale price of the business would not be affected by this choice. Instead, the sale price would simply reflect a lower multiple of the SDE or a higher multiple of the EBITDA. This is because serious buyers calculate their own earnings metrics from the raw accounting data and act accordingly. 

So it is useful for sellers to understand these metrics and choose ones that portray the business in the best light. Getting the attention of the right buyers is critical. But ultimately the negotiation of the sale price and deal terms will come down to the buyer’s estimation of the future profits the business will generate under new ownership, and how important it is to him or her not to miss out on the acquisition opportunity (which will be related to the handling of the sale process itself, including the ability to create a competitive bidding process).

In our next two posts we will explore some of the small business sales data that is available, and discuss how to interpret it.