The ‘True’ profit of a business
For a seller or buyer to value a business appropriately, it is important to understand ‘Sellers discretionary earnings’ (SDE). SDE represents the entire financial benefit a business will provide to an owner. It is not simply just looking at EBITDA or net profit, as it may include many expenses which the new buyer may not utilise. These items can be described as discretionary expenses.
For buyers, understanding this can assist in more accurately predicting the potential return on investment. This will provide an idea of the realistic earnings.
For sellers, it is an important consideration as it allows them to potentially maximize the value of the business. The valuation is based on a multiple of earnings, so the higher the earnings are, the higher the valuation.
The ultimate goal of SDE is to properly identify what a new owner can reasonably expect for earnings. A buyer should go one step further and include adjustments based on their proposed vision and strategy of running the business. This may include hiring additional staff or hiring facilities which in turn will provide the buyer with a ‘true profit’ of operating the business.
The following is an example of how this process is formulated. Note that items removed are expenses are that considered discretionary for the seller or that the buyer would not be responsible for after purchasing the business.
The purpose of focusing on a seller’s discretionary earnings is to provide a consistent number that can be used as a baseline for the buyer and allow them to determine how much earnings they will be receiving from the business.
A buyer’s circumstances will differ to that of the seller and it is crucial that the buyer considers expenses based on their own strategy when taking over the business.
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Disclaimer
This article is provided with the compliments of Alan Dinnie. It is genuinely intended to offer readers information to make better decisions and to give insight into various aspects of business in general, and more particularly related to the sale and purchase and management of businesses.
All material presented herein is intended for informational purposes only. Information is compiled from sources deemed reliable but may be subject to errors and omissions. No statement is made as to the accuracy of any description. Alan Dinnie makes no warranties or representations regarding the information and excludes any liability which may arise because of the use of this information. This information is the copyright of Alan Dinnie.
Nothing herein shall be construed as legal, accounting, or other professional advice outside the realm of real estate and business brokerage.
I trust you enjoy the article and that it provides you with useful information.
To your business success
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