Valuation: What are Discretionary Earnings?

It’s good to be an owner.  Let’s list some benefits.

The question every Buyer will ask is, “how much money does this business actually make?”  From this number Buyers will begin to determine the business’ value.  You may have heard the statement that a business is only worth what a Buyer is willing to pay for it, right?  Well, Seller’s Discretionary Earnings (SDE) represents the value that the current owner gets from the business, and is the basis for the Buyer’s perception of value.

I think of this number as representing the true net benefit to the current owner. 

What are Discretionary Earnings (DE)?

After analyzing the tax return, and financial statements and having conversations with the owner, we are able to “recast” the earnings to show a more thorough representation of the business’ true cash flow.  For example, some portions of fairly typical expenses may have non-business elements, such as auto expenses, telephones and related plans, health insurance, and more.  Hopefully, you get the idea.  Core operational expenses required to run the business are left to stand on their own.  The current owner or the next owner would have to pay these in any case.  The “fringe” benefits are at the owner’s discretion and we want to add them back into the net income value.

Other non-cash deductions like depreciation, amortization and interest should also be added back into the recast of earnings.  Why?  In the case of depreciation, that is essentially just a tax-based method of gradually turning a capital expense (Cap Ex) into an operational expense (Op Ex) over a few years.  In the case of interest expense, we add that back because the choice of paying for something outright or getting financing is at the owner’s discretion, so just strip the interest expense out and show it as cash flowing to the owner.  Who knows what another owner might have done in the same situation?  Different Bank, or better rate?  Pay cash?  Again, we try to normalize all of these elements into one number that shows a Buyer how much cash flow to expect.

A word of caution to Sellers; a Buyer will want you to show evidence of all the discretionary items that have been added back into the SDE value.  If they are going to buy it, you have to support it.  So beware of having huge or oddball expenses that you want to add back in the recast.  Buyers will understand your desire to leverage the tax advantages you enjoy as an owner, but they won’t want to pay for anything that you can’t justify or support during the due diligence process.

If you are a seller and want to learn more about this or any portion of the sale process, call me and let’s have a conversation.  I can help!