Go Forth and Multiply!

The Importance of Cash Flow and Multiples
November 4, 2022

One of the (few) things I learned at business school was that “Cash is King” - but measuring cash can be a nuanced exercise. When companies are sold they are often valued based on a multiple of cash flow. You may hear that a company was sold for four times earnings before interest, taxes, depreciation and amortization (EBITDA) - but in relation to small businesses, you may also hear the price expressed as a multiple of seller’s discretionary earnings (SDE). Channeling Jerry Seinfeld, what’s the deal with that?

In the case of both SDE and EBITDA, non-cash expenses such as depreciation and non-recurring expenses are added back to the net profit, as are expenses not related to the operation of the business (e.g. the salary paid to the deadbeat son in law playing Xbox in the back office). However, owner salaries and benefits are treated differently under each of the calculations. To calculate SDE, all of these expenses are added back to net profit. The assumption is that the buyer will actively manage the business and the SDE measures the total cash flows that they might enjoy as an owner/operator. To calculate EBITDA, the seller’s salary and benefits will be added back only to the extent that they exceed the market rate to hire someone to fill the roles that they fulfilled. Here the assumption is that the buyer could engage someone to manage the business and the EBITDA cash flow represents only the return that an investor in the business could expect. As a result, the SDE for any given company is normally higher than its EBITDA.

A second key difference relates to what is included in the price determined using each cash flow measure. By convention, the SDE multiple includes a company’s fixed assets and its goodwill. Therefore in a transaction based on SDE it is necessary to add to the amount determined by the use of the multiple the value of its cash, accounts receivable and (often) inventory and subtract all of the company’s liabilities. For transactions using the EBITDA measure the convention is that the price also includes a normal level of working capital i.e. its accounts receivable less its accounts payable.

The result of these differences is that the EBITDA multiple will be higher than the SDE multiple for the same company since the EBITDA cash flow used for the price calculation is lower and it includes more assets (i.e. the company’s net working capital). You can see this from the example below. Assuming an SDE multiple of two, the equivalent EBITDA multiple for the same company would have to be 3.4 to result in the same ultimate value.

The Pepperdine Private Capital Markets Report includes a survey of business brokers which gives us some insight into when each measure is used. The survey showed that the use of SDE multiples was prevalent when the ultimate price of the deal was below $2 million, whereas it was rarely used for deals priced above $5 million where EBITDA reigned supreme. Which brings me neatly back to the regal conceit that I started this article with!