Discretionary Earnings or DE is the total economic benefit the owner derives from the business.
This includes the net profit plus owner’s salary, benefits, personal, and other non-operational expenses that are run through the business.
DE is very important because it the primary earnings value used to determine the market value for companies under $5 million in revenue and $1 million in earnings.
To calculate DE start with the Net Profit shown on the business Tax Returns, then add back the owner’s salary (must be W2) and all owners benefits and expenses. While this may appear, finding and determining these add backs can be complicated. An experienced business broker can accurately recast the financial statements to calculate the correct DE for a business.
IMPORTANT NOTES:
ALL owner’s expenses/benefits MUST be shown on the tax returns under an expense line item and be verifiable. If the expense is not shown on the tax return, it cannot be added back and counted toward DE.
Distributions: Note that Distributions or Dividends are NOT part of the owner’s salary or compensation. This is a balance sheet transaction and is NOT an expense on the Pu0026amp;L. Thus it cannot be added back as it is not a P-L expense.
DE is used in most valuation methods including SBA lenders.
EBITDA (Earnings before Interest Taxes Depreciation and Amortization) is also used in valuations, the difference between the two is that DE includes the owner’s salary and EBITDA has a manager’s salary included in the company expenses. EBITDA is essentially the earnings of the business if it is absentee owned with a manager running the day to day operations.
Valuation multiples for DE are lower than those for EBITDA as the DE multiple is applied to a larger earnings figure, and EBITDA multiples are applied to much lower earnings figures. The results are generally close if the earnings are calculated correctly.
EBITDA (Earnings before Interest Taxes Depreciation and Amortization) is also used in valuations, the difference between the DE and EBITDA is that DE includes the owner’s salary and EBITDA has a manager’s salary included in the company expenses. EBITDA is essentially the earnings of the business if it is absentee owned with a manager running the day to day operations.
Valuation multiples for DE are lower than those for EBITDA as the DE multiple is applied to a larger earnings figure, and EBITDA multiples are applied to much lower earnings figures. The results are generally close if the earnings are calculated correctly.
The definition of EBITDA is Earnings Before Interest, Depreciation, Taxes, and Amortization. For very large companies this can be calculated directly from the Tax Return or P&L and is relatively straightforward to determine. For small businesses calculated EBITDA it is more complicated because most small businesses have owner’s benefits, expenses, and other non-operational expenses are included in the company’s expenses.
For small businesses, Normalized EBITDA is used. Normalized EBITDA is calculated much like DE (Discretionary Earnings) by adding back the owner’s benefits and expenses, and then subtracting a salary for a General Manager or CEO to replace the owner at market rate. Note that many sellers take salaries higher than market rate, while others may take a lower salary, so the adjustment is necessary.
Discretionary Earnings (DE) multiples are lower than EBITDA multiples because the two earnings figures are very different. Generally speaking, you can expect the DE for a small business to be approximately $100,000 to even $250,000 higher than the EBITDA figure. (this is a generalization, the correct figure should be calculated for each business)
This is because DE includes the owners salary and benefits, and EBITDA has compensation for a GM or CEO to replace the owner included or added into the expenses.
In general, EBITDA multiples for small businesses are in the 4X range and DE is in the 2 to 3.25X range. NOTE these figures vary by the type of business and industry as well as the size of the business. NEVER use a guess or “average” figure for the earnings multiple. Comparable sales data and earnings multiples are available from Peercomps.com and DealStats
It also important to note that some multiples include working capital and others do not. Peercomps data and multiples do not include working capital, cash, or A/R. Dealstats does.
DE (Discretionary Earnings) is primarily used for small businesses, under $5 million in sales and $1 million in DE (earnings).
EBITDA is primarily used for larger businesses, over $5 million in revenue and $1 million in EBITDA.
Valuation Analysts and SBA lenders frequently use both DE and EBITDA multiples and blend the results for mid-size businesses, so it is common to see both used.
Discretionary Earnings (DE) is Net Profit from the tax return plus the owner’s salary, personal expenses, and non-operational expenses (add-backs). Add-Backs are a critical factor in calculating DE and often can add up to well over six figures. Thus, it is important to get this figure right.
In order to be a valid add-back, the expense MUST be shown on the tax return as an expense line item or included in one of the line items or statements. For example, travel, office expense, marketing, auto expense, insurance, etc. The add-back must also be verifiable.
SBA lenders generally will not accept any add-backs in COGS (Cost of Goods Sold) or materials because it is difficult to differentiate between the owner’s claimed expense and normal operating expenses.
Distributions and/or Dividends are NOT an add-back and are NOT included in the DE or EBITDA calculation. Distributions are essentially a cash payment to the owner from the balance sheet and are not an operating expense that can be added back.