Net profit, EBIT, EBITDA and SDCF: what is the correct metric for business valuation?

The most commonly used “earnings figures” for valuation of small and medium-sized businesses are net income (IN), earnings before interest and taxes (EBIT), earnings before interest, taxes, depreciation, and amortization. (EBITDA) and the seller’s discretionary cash. Flow (SDCF). With a variety of metrics to choose from, it is natural for a business owner to wonder “which one is right for my business.” To answer the question, we first need to quickly know what these earnings metrics are.

Ø NI: NI is the net profit of the business after deducting all the expenses of the business, including all operating expenses, the salary of the owners or officers, interest expenses, taxes, etc. Some people consider this to be “true earnings,” but for many small and medium-sized businesses, who are in a constant quest to minimize taxes, this number can be grossly underestimated and is not a true reflection of the company’s earnings stream.

Ø EBIT: EBIT is the net profit of the business before including financing and taxes. The reason for using this metric is that tax payments are highly accountable and dependent on the owner, and a pre-tax view of earnings would be a better indicator of earnings stream. Similarly, interest payments that are a function of the company’s financing strategy and vary widely depending on the debt-to-equity ratio the property prefers. The resulting leverage factor can artificially inflate or deflate the IN. EBIT shows an earnings number that adjusts for these variables to reflect a more realistic picture of earnings.

Ø EBITDA: The accounting treatment of Depreciation and Amortization for many companies is substantially different from the real impact of the cash flow that these elements have on the company. EBITDA allows you to analyze the profitability of the business before factoring these two elements. Keep in mind that this can be a very misleading indicator based on the depreciation and amortization characteristics of the business and adjustments to EBITDA are almost always necessary 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 salary, benefits, and other benefits.

Effectively,

Ø EBIT = Net Profit + Interest + Taxes

Ø EBITDA = EBIT + Depreciation + Amortization

Ø SDCF = EBITDA + Owner / Officer Salary + Benefits + Benefits

So the answer to the question, “What profits are right for my business?” It depends on the nature and size of a business and understanding which metric can most accurately reflect actual earnings. For many midsize companies, the appropriate metric is likely to be EBIT or EBITDA.

Once the correct metric is identified, the business owner must understand the range of multiples that may be applicable to the chosen metric. For example, earnings multiples for most small companies tend to vary between 1 and 3 times the SDCF and the multiple of earnings for medium-sized companies are more likely to be 3 to 5 times EBIT or 3 to 7 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 is outside the typical range.