Net income, EBIT, EBITDA and SDCF: what is the correct metric to use for business valuation?
The most commonly used “earnings figures” for valuing small and medium-sized businesses are Net Income (NI), Earnings Before Interest and Taxes (EBIT), Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA), and Bank Discretionary Cash. Flow vendor (SDCF). With a variety of metrics to choose from, it’s natural for a business owner to ask “which one is right for my business.” To answer the question, we first need a quick rundown of what these earnings metrics are.
Ø NI: NI is the net profit of the business after deducting all business expenses, including all operating expenses, salary of owners or officers, interest expense, taxes, etc. Some people think of this as “actual earnings,” but for many small and medium-sized businesses, which are on a constant quest to minimize taxes, this number may be grossly understated and is not a true reflection of the company’s earnings stream.
Ø EBIT: EBIT is the net profit of the company before taking into account financing and taxes. The reason for using this metric is that tax payments are highly accounting and owner dependent, and a pre-tax view of profits would be a better indicator of profit stream. Similarly, interest payments are a function of the company’s financing strategy and vary widely depending on the property’s preferred debt-to-equity ratio. The resulting leverage factor can artificially inflate or deflate the NI. EBIT shows an earnings number that adjusts for these variables to reflect a truer picture of earnings.
Ø EBITDA: The accounting treatment of Depreciation and Amortization for many businesses is substantially different from the actual cash flow impact these items have on the business. EBITDA allows us to see the profitability of the business before taking these two elements into account. It should be noted that this can be a very misleading indicator based on the depreciation and amortization characteristics of the business and it is almost always necessary to adjust EBITDA to get a true picture of earnings.
Ø SDCF: For smaller businesses, where the owner may view the business as a “job,” the true measure of profitability may be the sum of all the money the owner makes from the business, including wages, benefits, and other perks.
Ø EBIT = Net Income + Interest + Taxes
Ø EBITDA = EBIT + Depreciation + Amortization
Ø SDCF = EBITDA + Salary of the owner/employee + Benefits + Benefits
So the answer to the question “Which earnings are right for my business?” It depends on the nature and size of a business and an understanding of which metric can most accurately reflect actual earnings. For many mid-market companies, the appropriate metric is likely to be EBIT or EBITDA.
Once the correct metric is identified, the business owner needs to understand the range of multiples that can be applied to the chosen metric. For example, earnings multiples for most small companies tend to range between 1 and 3 times SDCF and earnings multiples for midsize companies are more likely to be 3 to 5 times EBIT or 3 to 7 times SDCF. times the EBITDA.
However, businesses tend to be more unique than typical, and a multiple that is good for one business may be too low or too high for another. The more exceptional the business, the more likely the multiplier will be outside of the typical range.