The Differences Between SDE And EBITDA
Buyers use SDE (seller’s discretionary earnings) or EBITDA (earnings before interest, taxes, depreciation, and amortization) to estimate the free cash flow of a company. The number used depends on who the potential buyer is.
SDE reflects the cash flow produced for an active owner, meaning that the owner is involved in the management and daily operations of the business. This measure is generally relevant to smaller businesses, typically with earnings below one million dollars. SDE does not deduct the salary of the owner-operator or other business expenses because it assumes that the owner will be the beneficiary of all the earnings of the company. With respect to the purchase of FedEx routes in particular, SDE is most often the cash flow estimate under consideration.
By contrast, EBITDA is the measure preferred for the financial buyer who does not plan to have an active daily role in business operations. Private equity groups, family offices, and large strategic buyers consult this estimation, and it is generally applied to businesses with earnings over one million dollars.
The interesting aspect of EBITDA is that it allows for the estimation of free cash flow without any consideration placed on the capitalization of the company or the tax circumstances of the owners. Additionally, sellers can add back any expenses that are exclusive to that owner. By way of example, a seller might add back the salary paid to a family member who has no functional roll in the company to reflect a more accurate picture of the true earnings of the business.
EBITDA seems complex because it is a long acronym with technical terms; however, it is quite understandable once you break it down into its components. For starters you remove interest because it is correlated with how you have chosen to capitalize the company. Since this decision is unique to each buyer, it is removed from the EBITDA estimation.
Secondly, taxes are removed, again because each buyer has an individual tax situation that may not correspond to that of the seller. Depreciation is deducted because it is a non-cash expense. An example of depreciation for a FedEx purchase may be that your trucks depreciate over time, lessening their sale value. You cannot do anything about that really, so depreciation is removed from the equation. Finally, amortization is taken out of the picture because it also is a non-cash expense. Since these numbers are highly individualized, they are not relevant to the calculation of EBITDA.
The story of value computation is never so simple though, and there are several more factors involved in the esoteric calculus of valuation:
- Larger purchases = Higher multiples
- Buyers believe that a larger purchase represents lower risk. For instance, the larger FedEx route purchase that the buyer chooses, the more recession-proof it will be. The more employees one employs and the more the trucks one owns, the more resilient the continuation of deliveries will be in the face of adversity.
- Larger markets = Higher multiples
- FedEx routes in larger cities fare better than routes in smaller markets. There is more growth potential in such markets, and the desire for home delivered goods shows no signs of flagging since the Covid pandemic rocked markets a year ago. Subscription services are ubiquitous, and the probability that home delivery has a good future is strong.
- Growing companies = Higher multiples
- Growth receives a premium because buyers are receiving a stream of cash flows, and buyers are assuming cash flow growth. One cannot stress enough that the retail-to-delivery swap-‘em-out is likely a new fixture of the home delivery economy. There is still plenty of growth in the FedEx delivery sector, and it is likely that FedEx will experience plenty of growth in business in the foreseeable future.
Conclusions:
The difference between SDE and EBITDA is that they estimate the cash flows of companies (or FedEx routes) differently based on who will be the potential buyer.
It is the job of Black Iron Advisers to determine whom the most likely buyers are, calculate the most relevant measures of cash flow and valuation, and present either SDE or EBITDA numbers to the party interested in a transaction. They are also capable of assisting you to improve the SDE and EBITDA of your business before you bring it to market. They have a strong history of optimizing business earnings before going to market. Their devotion to a client first philosophy stands at the forefront of their practices, and they are devoted to creating win-win situations for all of their clients.