This is a million-dollar question for the seller, and a rough answer is usually surprisingly easy. However, when you Google the answer, you usually find a long essay discussing various valuation models (e.g., Income Approach, Market Approach, Cost Approach).

EBITDA, Adjusted EBITDA, and DE/SDE/SDCF – Understanding the Industry Jargon

All of the above is true, but in practice, a majority of buyers (and banks who fund them), follow a relatively straightforward method in valuing a profitable business – which is either a multiple of EBITDA or a multiple of Discretionary Earnings (DE), also known as Seller’s Discretionary Cash Flow or Seller’s Discretionary Earnings (SDCF, or SDE). EBITDA is typically used for a business of reasonable size (say over $1 Million in revenue). In contrast, the DE is usually for smaller and normally owner-operator types of companies where the business owner is fully involved in the day-to-day operations.

EBITDA stands for Earnings before Interest, Taxes, Depreciation, and Amortization (yes, it is a mouthful). But essentially, you take the net earnings of the business, add back the interest expense, state and federal income taxes, depreciation, and amortization, and you get the value of EBITDA. In practice, we always use Adjusted EBITDA rather than ‘pure’ EBITDA because in businesses, often there are “discretionary expenses” that are not business-related and also one-time expenses, such as specific amounts of capital expenses which are typically not usual but are expensed out in one year, instead of being on the balance sheet, for tax benefit. So, the EBITDA is adjusted by “adding back” these types of expenses, often called “add-backs.” So by adding these ‘add-backs”, one gets the Adjusted EBITDA. One example of add-backs is higher than the market salary for the owner, in which case you add back the excess salary paid. If the owner’s salary is below the market rate, you subtract the amount that will bring the salary to the market salary. Other examples of add-backs are personal car at the company expense, owner’s wife or son on the payroll even if they are not involved in the regular work.

Once you have this magic Adjusted EBITDA number, you can estimate your business’s value by multiplying this EBITDA by a multiplier. This is where it gets a bit interesting. For example, for a small business with revenues of, say, between $1-$5M and EBITDA under $1M, the multiplier is typically between 2.5-4.5 but usually between 3-4. Depending on the type of the business, it could be higher or lower than this range or on the high or low end of this range. Some factors that decide where it will fall are discussed in the section for Sellers and determining your Value Builder score. However, the most important thing to remember is that a correct value is what a buyer is willing to offer at a given time, depending on how badly he or she needs it.

Also, remember that as the size of the business becomes more significant, it attracts higher multiples – EBITDA multiples could go up to 5-8 for businesses that are much bigger in revenues and EBITDA, or sometimes even higher depending on the type of business and demand for those businesses. Remember the famous saying – value is in the eyes of a beholder. A strategic buyer who cannot capture a particular customer base because he or she lacks specific capabilities, geographic presence, or some certifications could quickly pay a premium for a particular business. For that buyer, the price is justified.

What about owner-operated smaller businesses using DE or SDCF instead of EBITDA? DE or SDCF, in simple terms, is EBITDA plus owner’s compensation, and the valuation multiple is generally in the 2-3.5 range for DE.

However, having said this, ultimately, the price comes down to what a buyer is willing to pay for a particular business at a specific time period and how badly the buyer wants it. If the buyer wants it bad enough, he or she will pay a premium.