One of the most important things you can do in a business valuation is to determine the earnings basis. Most income and market-based business valuation methods take some form of cash flow as its earnings input. Since accounting measures of business earnings usually require adjustments, calculating the earnings basis right can make a major difference to your business appraisal.
One common measure of business earnings used in private company valuations is seller’s discretionary cash flow, or SDCF for short. Here is how you can calculate this figure:
- Start with the company’s pre-tax net income
- Add back non-operating expenses and subtract non-operating income, if any
- Add back one time or extraordinary expenses
- Add back paper expenses such amortization and depreciation
- Add back interest expense
- Add back the principal owner’s total compensation
- Adjust the compensation of the remaining owners to market, known as manager replacement
Depending on how the rest of the business owners get compensated, this manager replacement adjustment can increase or decrease the available business cash flow. For example, if the business owners are relatively underpaid for their services, your SDCF figure will be reduced by the appropriate amount. The idea is that a potential business buyer will need to replace the departing business owners with professional managers who will expect to be paid adequately for their work.
On the other hand, some owners may be currently paid more than their contribution would warrant. In this case, the new business owners will likely be able to replace these functions at a lower cost. The result is higher SDCF.
Either way the manager replacement adjustment is very important. It is a very good idea to carefully review all the functions performed by current business owners and determine the associated labor costs at market levels.
Multiple of Discretionary Earnings method is one of the best known ways to value a business based on seller’s discretionary cash flow.