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
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:
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
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
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)