How to validate SDE multiple?

December 09, 2024

by a searcher from University of Toronto - Joseph L. Rotman School of Management in Toronto, ON, Canada

I'm currently looking at a deal with the following characteristics....
- 3 years of revenue and SDE declines, but a significant increase for###-###-#### expected)
- Company is fairly saturated in terms of market share (i.e. it can grow, but I don't see it doubling / tripling)
- Fully reliant on government funding (Canada)

It is listed at 3.4x the 3-year SDE average. Of course every deal is not created equal, but I'm trying to see if there's a data-backed way to go about the valuation. Hoping to avoid two people with differing opinions on what a reasonable SDE multiple should be.

Would love some insight on how to find and validate an appropriate SDE multiple. Thanks!

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Reply by a searcher
from University of Michigan in Bay City, MI, USA

Using SDE, at least the way most brokers and sellers present it, is a bad way to try to value a business. At best, with "not tiny" deals ($500k+ SDE), it's merely not terribly misleading. With businesses smaller than that, you can get to a point where fair market compensation for the work being done by ownership - which has basically no value in a cash flow valuation and shouldn't have a multiple applied to it - can be 60-80+% of the stated SDE. In that case, any "rule of thumb" multiple is likely going to drastically overvalue the business.

At its core, any "multiple" valuation is just shorthand for approximating future cash flows, assuming the past is representative of the future. That's a good starting point, not a good ending point, IMO. As ^redacted‌ said above, you really need to do your own pro forma projections. Will you be guessing some? Sure. But your best guess + sensitivity analysis is almost certainly better than just assuming everything will stay the same (which is what multiple-based valuations do).

Reply by an intermediary
from Indiana University at Bloomington in Carmel, IN, USA

Thanks ^redacted‌ for the Tag. Multiples of earnings (either SDE or EBITDA) are good to ballpark. Looking at the multiple databases (PeerComps is another one), generally for a business under $600K, you can use SDE and the Average is 2.78, just about in every industry. We use recast EBITDA over $600K as the Owner's comp becomes less of a % of the cash flow, and that multiple is @ 3.78. But with both, there is a standard deviation of 25%+/- based upon all the soft factors (non-financial). As is stated above, what you are trying to estimate is the go forward earnings, for that you have to look at the cash flow, add backs, what you are going to be paid, debt service, CapEx and then the banks will want on the low end a 1.4 Debt Coverage Ratio. That in my opinion is how to price out a business: with your down payment, how much can you finance.

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