What did he say? What junk. All saying much the same thing in a different way. First of all let me clear up the confusion about all these crazy letters.
1. What is DCF? Discretionary Cash Flow or Discounted Cash Flow? Big difference. Discounted Cash Flow is a valuation method taking into account the net present value of future income projections. This is not what we are talking about, we are looking at Discretionary Cash Flow or Seller’s Discretionary Cash Flow (SDCF). This is essentially all of the company net earnings before tax and before paying all the owner his perks and salary.
2. SDE. Seller’s Discretionary Earnings. Is this any different from the SDCF above? Not really, nor is it any different from OB or owner’s benefit. These three terms are used in much the same way by most brokers. They are used to add back everything but the kitchen sink to the earnings picture to show the most favorable picture possible when selling the company.
3. EBITDA, Adjusted EBITDA or EBIT. Earnings before interest, Depreciation and Taxes. It actually is quite descriptive and accurate. It is similar to the SDCF methods in that it adds back everything owner related, salary, perks, bonuses and extraordinary expenses, but it then proceeds to subtract out a market compensation package to allow the company to be valued on a stand alone basis.
4. NOI. Net operating income. We won’t say too much about this because we do not use it in the valuation process. However it is significant as a starting point with which to arrive at all the other metrics. NOI is a raw number, not adjusted for anything. It is a pretax earnings number from which all other adjustments are made.
Let’s say we want to examine earnings of a company in a pitifully simple way. Here is the important question. Do we want to examine the earnings before or after we pay somebody to run the company? The difference is very significant when valuing the company. The SDCF methods are used usually when a company is very small and most of the value is wrapped up in the amount of money the business will pay to the owner for working there. EBITDA methods are used when the company is bigger and the value is based on what the company earns when the owner is NOT there. It thus treats the owner as an investor as opposed to an employee. It should be noted that the three SDCF methods are “adjusted” for owner’s perks and any expenses or income that would not be there after someone buys the company. Similarly EBITDA must be adjusted for the same items. These adjustments are called “addbacks” because they are usually amounts that are added back to earnings to make an accurate picture of what the company’s profit picture after the sale.
Thus in most cases Adjusted EBITDA will correspond to the three SDCF methods with the only difference being that EBITDA will not add back the owner’s salary, perks or bonuses in full. It will only add back the excess owner related amounts and “normalize” the earnings picture as if there was an employee managing the company at market compensation.
This is not to be confused with EBITDA or EBIT the latter two (earnings before Interest, Taxes and/or non-cash items) representing the earnings available to the owner AFTER paying someone else to work the 12 hour day running the company.
I will touch on EBIT just briefly because it is similar to EBITDA except it does not add back Depreciation and Amortization into the earnings analysis. One would expect a lower valuation because it will be a lower earnings number than EBITDA. Why would anyone use this number? Shouldn’t Depreciation be added back to a cash flow related earnings number? Not always. Suppose the company in question owns a massive amount of equipment and thus records a massive amount of depreciation. They may also have a massive amount of repairs, debt service and capital expenditures for maintaining said equipment. In this case adding back depreciation may not be accurate because there are so many offsetting expenditures related to the corresponding assets.
SDCF valuation methods are generally used in the very small markets where the theory is the buyer will be working inside the company. Adjusted EBITDA valuations assume the buyer will not be working in the company. One is suited for an owner/manager the other for an investor. We concern ourselves with EBITDA and EBIT because at no time do we intend to work inside the company. Moreover, using the same multiple and company, the SDCF valuation will be higher than using EBITDA or EBIT. This is because you are essentially adding the managers salary into the equation to get DCF. Not so with EBITDA or EBIT.
So the point is get into the habit of using EBITDA even if a broker wants to quote DCFs. EBITDA puts you in the role of an investor, which you are. Or if you aren’t you should change your mindset to do so because it will expand your horizons and save you money.