What is Seller’s Discretionary Earnings (SDE)?
Seller’s Discretionary Earnings (SDE) measures the normalized, operating profitability of small to mid-sized businesses (SMBs).
Conceptually, SDE represents the earnings of a small business before income taxes, non-operating income and expenses, owner’s compensation, non-cash add backs (depreciation and amortization), interest expense or income, and non-recurring items, including personal expenses.
- What is Seller’s Discretionary Earnings (SDE)?
- What is the Definition of Seller’s Discretionary Earnings?
- How to Calculate Seller’s Discretionary Earnings (SDE)
- Seller’s Discretionary Earnings (SDE) Formula
- SDE vs. EBITDA: What is the Difference?
- SDE Calculator — Excel Template
- Seller’s Discretionary Earnings (SDE) Calculation Example
What is the Definition of Seller’s Discretionary Earnings?
SDE stands for “Seller’s Discretionary Earnings” in business and reflects the normalized profits that a company, most often a small business, generated on behalf of its owner across a given period.
The seller’s discretionary earnings (SDE) metric is intended to be a quick approximation of an SMB’s free cash flow (FCF).
In practice, the SDE metric is most prevalent under the context of M&A for small to mid-sized businesses (SMBs), where a prospective buyer conducts diligence on the target SMB to determine the merits and risks of the potential investment.
Therefore, the seller’s discretionary earnings (SDE) metric estimates the monetary benefits that a business has generated on behalf of the owner to date.
How to Calculate Seller’s Discretionary Earnings (SDE)
The calculation of the seller’s discretionary earnings (SDE) metric can be broken down into the following step-by-step process:
Step | Description |
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Step 1. Determine Pre-Tax Income (EBT) |
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Step 2. Normalize Owner’s Salary (Including Payroll Taxes) |
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Step 3. Add Back Non-Cash Expenses (D&A) |
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Step 4. Add Back Interest Expense, net |
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Step 5. Add Back Non-Recurring Expenses |
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Step 6. Add Back Discretionary Expenses |
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Seller’s Discretionary Earnings (SDE) Formula
The seller’s discretionary earnings (SDE) profit metric reflects the normalized earnings of an SMB prior to the owner’s salary, interest, income taxes and non-cash expenses, such as depreciation and amortization (D&A).
The formula to calculate SDE is as follows.
SDE vs. EBITDA: What is the Difference?
The SDE and EBITDA are two different methods to measure the profit potential of a particular company.
The adjustments applied to EBITDA and SDE are relatively similar, with the primary benefit being related to comparability (i.e. they facilitate more uniform, “apples-to-apples” comparisons).
However, the one notable difference between SDE and EBITDA is in the adjustment for the owner’s salary.
Unlike EBITDA, the SDE metric includes adjustments to the owner’s salary, including the discretionary spending of company funds on personal expenses like meals and travel.
The range of companies that the SDE metric is measured for is much more limited, too, in comparison to EBITDA, which is used to analyze companies of all sizes.
SDE vs. EBITDA vs. Adjusted EBITDA (Source: Morgan & Westfield)
SDE Calculator — Excel Template
We’ll now move on to a modeling exercise, which you can access by filling out the form below.
Seller’s Discretionary Earnings (SDE) Calculation Example
Suppose you’re tasked with calculating the seller’s discretionary earnings (SDE) profit metric of a small business given the following last twelve months (LTM) financials.
- Pre-Tax Income (EBT) = $400,000
- Owner’s Compensation = $100,000
- Interest Expense, net = $30,000
- Depreciation and Amortization (D&A) = $40,000
- Discretionary Expenses = $60,000
- Non-Recurring Expenses = $10,000
The calculation of the company’s SDE on an LTM basis is straightforward, as we adjust pre-tax income (EBT) by adding back the owner’s compensation, interest, D&A, discretionary expenses and non-recurring expenses.
In conclusion, the sum comes out to $640k, which reflects the concept of seller’s discretionary earnings (SDE).
- Seller’s Discretionary Earnings (SDE) = $400k + $100k + $30k + $40k + $60k + $10k = $640k