I work with a large network of local business brokers. I get a lot of referrals from them. In the course of talking with them, one asked me why we (appraisers) do not seem to use seller’s discretionary income (“SDE”, or earnings before owner’s compensation, interest, and tax expense) very much in our appraisals. After all, he said, “I know what the market multiples are, I have sold a ton of businesses using SDE and my knowledge of the right multiple. It is pretty easy to figure out SDE and the right multiple.”
I answered this way:
You certainly can use SDE and rely on your knowledge of the market; after all, you are in it every day! There is nothing wrong with it at all!  We appraisers use it, too, when we have enough facts and figures available to back up our work.
The problem appraisers have is that much of the time we can’t find enough comparables (guidelines) with accurate or consistent data (SDE and sale price).
If we don’t have at least five comparables, we are skating on thin ice as far as supporting our opinions before the courts or the IRS. So we have to use other data (like price to sales ratios) or other methods (like discounted cash flow) to support our conclusions, because we have better and more data to back them up.
Now, let me ask you this: how do you back up your opinion of the right multiple? If I am going to buy a business, I want to know what my rate of return on investment is going to be. Just because you (the seller’s broker) say a multiple is right, what does that mean for me, the buyer? How do I know if that is reasonable?
I can help you answer that question by showing you and the buyer how to justify the price in terms of the rate of return on investment!Â
THAT got his attention!
I went on to explain how we analyze SDE, dividing it into fair market compensation (reasonable return on labor for the buyer’s service as manager of the business) and profit over and above that available for dividends or distributions (return on equity investment). I then showed him how to calculate return on investment as profit (cash flow) after compensation divided by the purchase price, and how to illustrate that in a simple table.
He immediately understood how valuable this would be to him: he could use my help to test a seller’s expected price against the implied ROI to see if it was feasible, to price his clients’ businesses much better for probable sale, and how to prove to a buyer that the price is justified.
These jobs are usually easy, quick, and inexpensive…brokers also like to suggest that clients retain me so the brokers can judge how serious the clients are about selling. If someone isn’t willing to invest in a limited calculation engagement like this (it is not a full appraisal), then they may not be serious about selling, and the broker needs to know that before he or she wastes much time.