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EBITDA is Helpful but Discretionary Earnings are Optimal

In the past years there have been a number of articles criticizing EBITDA and a multiple thereof

to determine a company's value. EBITDA is an acronym for:


"Earnings before* interest, taxes, depreciation, and amortization."

*Note: the word “before” can be read as “plus”.


It has been used extensively since the 1980's as a quick measure of company's profitability

and cash availability by investment banks, commercial banks, investors, and mergers and

acquisition companies. This metric is easily calculated, easy to explain, and the information is

readily available from basic financial statements. The calculation and usage of the EBITDA

figure have always been criticized by business appraisers, but even banks and the Mergers &

Acquisitions Industry recognize its shortcomings.


In determining the value of a company, EBITDA is lacking some important elements that

may lead to over/underpayment by a buyer or over/under-pricing by a seller. Some of these

factors are:


1. EBITDA is not cash flow

2. It does not show the actual cash available to service debt, pay owner salaries, etc.

3. It is not a good multiple in comparing companies as depreciation and

amortization treatment can vary between companies

4. It does not include changes in long-term debt

5. It does not represent the amount of cash available to a hypothetical buyer

interested in acquiring the subject business.


There are others, but the key finding is that it does not truly reflect the availability of cash and

the ability of the company to service debt and sustain its operations and growth potential.

At BizEquity, we utilize a much more robust measure of cash flow in the form of

“discretionary earnings” and a modified “net cash flow” as well as EBITDA to reach our

conclusion of value.


Discretionary Earnings and Asset Sale Value

“Discretionary earnings” or “seller’s discretionary earnings” (SDE) or “adjusted cash flow”

(ACF), etc. is a more powerful measure of cash flow as it accounts for the tax-minimizing

behavior of private firm owners and revolves around a “return on owner’s labor” paradigm

rather than a “return on investment” paradigm. SDE or ACF is calculated as follows:


Discretionary Earnings

Normalized Pretax Profits           (after eliminating non-recurring/non-operating items*)

+ Owner Compensation**          (salary, payroll tax burden of around 7% plus perks or other “discretionary” outlays)

+ Non-Cash Charges                    (depreciation/amortization)

+ Interest Expense

Equals Discretionary Earnings***


*These “non-recurring” or non-operating cash flow adjustments are made in the final two entries on

Step 3. The line item described as “expenses” will increase the overall discretionary earnings and the

line item described as “revenues” will decrease the discretionary earnings.


**This amount should ALWAYS include the TOTAL ACTUAL COMPENSATION paid to the

PRIMARY (single) OWNER-OPERATOR, whether it is a small amount or a large amount. When

there are two owners, an adjustment must be made involving the comparison of what the second owner

is ACTUALLY paid versus what a hypothetical buyer would have to pay for a replacement employee at

MARKET COST. For example, a second owner may be paid around $200K in total compensation

(salary, payroll tax plus benefits) but the incoming hypothetical buyer (who is replacing the work effort

of the primary owner) must pay a new replacement employee only $100K to perform the same set of

work. This “extra” $100K in future annual savings must be included in the total discretionary

earnings figure used to value the business. This incremental $100K can either be added to the primary

owner’s compensation amount OR entered into the one-time expense line near the bottom of Step 3.


If the business is “absentee operated” (no owner contribution to day to day activities), it is proper to

include the top manager’s compensation in the owner compensation line.


***Also called “seller’s discretionary earnings or SDE” or “adjusted cash flow” or “normalized

earnings”, etc.


It is also important to recognize that any estimate of value which is presented as a “multiple

of discretionary earnings” will be an “asset sale value” (inclusive of inventory, FF&E plus

all intangibles such as tradename and customer base and goodwill). The average owneroperated

business in the US sells for around 2.3 time’s discretionary earnings, but the actual

multiple for any given business will vary depending on industry, size of earnings, company risk

factors, etc.


Accordingly, an “asset sale value” does NOT incorporate cash and accounts receivables and

other liquid financial assets NOR does it account for the liabilities (both ST and LT). The

“equity value” DOES incorporate and account for these other assets and liabilities, i.e.:


Equity Value = Asset Sale Value + Cash, A/R, etc. - Liabilities (short and long term)

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