One of the most widely used methods for business valuation is the capitalisation of earnings. There are several reasons why this method is so popular:
- It is straightforward in methodology.
- It uses simple arithmetic.
- It follows an annual or “single period” approach.
- The calculation doesn’t need to factor in inflation explicitly.
- It’s widely understood by buyers, sellers, judges, lawyers, and business brokers.
- It doesn’t rely on speculative future income estimates.
- It is a globally recognised method taught by major appraisal institutes.
- It can be applied without market data, although such data can support the capitalisation rates used.
For SMEs (Small to Medium Enterprises) in New Zealand, the most common measure of profit used is Seller’s Discretionary Earnings (SDE). This metric captures the underlying cash-generating capability of a business, providing an insight into its true profitability.
What is SDE?
SDE stands for:
- Seller’s Discretionary Earnings
- The figure before accounting for Owner’s Remuneration, Interest, Depreciation & Amortisation, and Taxation.
SDE measures a business’s underlying cash flow potential. It eliminates debates around the owner’s remuneration, financial leverage, and non-cash costs. This figure is also known as “Seller’s Discretionary Cash Flow.”
How to Calculate SDE
Financial statements often provide the basic data needed to calculate SDE. However, it’s crucial to carefully review these statements, as they might use tax minimisation strategies that obscure the true financial picture. Ideally, examine financial statements and tax returns for the past three years to identify any significant trends.
The Role of Add-backs
The financial statements of privately-owned businesses rarely present the full picture. Add-backs are used to adjust reported financials to reflect the economic reality of the business. Common add-backs include:
- Donations
- Bad debts
- Rent adjustments
- Adjustments for owner’s wages, superannuation, or other remuneration
- Hire purchase and leasing charges
- Gains or losses from fixed asset sales
- Interest paid or received
- Depreciation and amortisation
Why Are Add-backs Important?
Add-backs help portray the true earnings and assets of a business. They don’t alter history but provide a more accurate reflection of the business’s financial performance. Key areas to focus on include:
- Owner’s Wage/Salary/Superannuation: Most SMEs are sold to a single working owner. Therefore, the entire wage and superannuation of the owner are added back when calculating SDE to avoid debates around appropriate remuneration.
- Rent Adjustments: If the business owner also owns the premises, rent might not reflect market rates. An adjustment ensures the SDE calculation reflects fair market rental.
- Depreciation: This is a non-cash expense. In arriving at SDE, depreciation is added back to ensure the calculation reflects the actual cash flow potential.
Assessing Future Maintainable Earnings
While many buyers consider the most recent year’s profits as the best indicator of future earnings, it’s essential to assess the pattern across at least three years. Evaluating a weighted average that emphasises the latest figures can provide a more accurate picture of future maintainable earnings.
Selecting an Earnings Multiplier
Once SDE is established, market data from Bizstats can help you select an appropriate multiplier, leading to a market value estimation. This data acts as a ‘sanity check,’ ensuring valuations align with current market conditions.
For more insights or assistance with business valuation, contact us at Bizstats.report. We have data on thousands of SME sales across New Zealand, ready to guide your decision-making process.