Valuation Metrics: SDE vs. EBITDA vs. Free Cash Flow

Dedicated to my daughter, Amira — this guide is for you, so one day you can confidently evaluate businesses, buy wisely, and build generational wealth.

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1. Why We Care About Valuation Metrics

When you buy a small business, the biggest question is:
“What is it really worth?”

Different buyers look at different metrics:

• Owner-operators focus on SDE (Seller’s Discretionary Earnings) — what they can personally take home.

• Investors or absentee owners focus on EBITDA (Earnings Before Interest, Taxes, Depreciation, Amortization) — profitability after professional management.

• Long-term thinkers care about Free Cash Flow — the actual cash available after reinvesting in equipment and covering real-world expenses.

Real estate adds another layer: owning the property changes financing, risk, and total valuation.

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2. SDE (Seller’s Discretionary Earnings) – Best for Owner-Operators

What It Is

SDE shows the total financial benefit to a single owner working in the business. It adds back personal perks and one-time costs to net profit.

Formula:

$$\text{SDE} = \text{Net Profit} + \text{Owner Salary} + \text{Perks} + \text{Non-Recurring Expenses} + \text{Interest} + \text{Taxes} + \text{Depreciation} + \text{Amortization}$$

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Why It Matters

• Captures what you, as the owner, can realistically pay yourself.

• Includes salary and perks (company car, meals, etc.).

• Most common metric for “Main Street” businesses (gas stations, laundromats, small service companies).

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Valuation Range

• 2.0x–3.5x SDE (typical range for small businesses without property).

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Manager Reserve Rule

If you want the freedom to hire a general manager later:

• Subtract $5,000/month ($60,000/year) from SDE.

• This shows “freedom-adjusted cash flow.”

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3. EBITDA – For Larger or Absentee-Owned Businesses

What It Is

EBITDA removes owner perks and personal salary. It reflects profitability as if run by a professional team.

Formula:

$$\text{EBITDA} = \text{Net Profit} + \text{Interest} + \text{Taxes} + \text{Depreciation} + \text{Amortization}$$

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Why It Matters

• Used when businesses grow beyond $2M in revenue.

• Attracts institutional buyers or partners.

• Focuses on scalable, manager-run operations.

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Valuation Range

• 4x–8x EBITDA depending on size, industry, and systems.

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4. Free Cash Flow (FCF) – The Real Money

What It Is

Cash left over after paying for operations and reinvestments (new pumps, repairs, etc.). This is what owners can actually use for:

• Paying themselves

• Servicing debt (SBA loans)

• Reinvesting or buying more businesses

Formula:

$$\text{FCF} = \text{EBITDA} - \text{Capital Expenditures} - \text{Working Capital Changes}$$

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FCF vs Net Income

• Net Income = “Paper profit” (bottom line on tax return).

• FCF = “Real cash” (what’s left to use after all reinvestments).

Example:

• Net Income = $200K

• Depreciation = $40K

• – New Pumps = $50K

• – Inventory Increase = $10K
  
  

• FCF = $180K (not $200K!)

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5. Revenue Multiples – When Profit Isn’t Clear

Sometimes books are messy (e.g., cash-heavy businesses). As fallback:

• Use 0.5x–1.2x revenue for boring service businesses.

• Use 3x–7x revenue for SaaS/high-growth companies.

• Always validate retention, margins, and growth before trusting revenue multiples.

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6. Debt Service Coverage Ratio (DSCR) – Bank Test

Formula:

$$\text{DSCR} = \frac{\text{Cash Flow}}{\text{Debt Payments}}$$

• SBA requires DSCR >1.25 (business must generate 25% more cash than loan payments).

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7. Real Estate Considerations

Two Ways to Handle Property

Option A: Value Separately

• Price the business at 2–3.5x SDE (operations only).

• Add property value (appraisal or cap rate).

Option B: Blended Price

• Seller includes property in total asking price.

• Back out property value to analyze true business multiple.

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Cap Rate Method (for property)

If property generates $80K net rent and market cap rate is 8%:

$$\text{Property Value} = \frac{80,000}{0.08} = 1,000,000$$

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Why Property Changes the Deal

• SBA allows 90% financing on property + business.

• No landlord risk (rent hikes, lease disputes).

• Property can appreciate independently of business performance.

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8. Quick Valuation Example

Business:

• Net Profit: $150,000

• Owner Salary: $100,000

• Perks: $20,000

• Non-Recurring: $15,000

• Taxes/Interest/Depreciation: $30,000

SDE = $315,000

At 3x SDE = $945,000 (business only)

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If Property Worth $1M:

• Total = $945,000 (business) + $1,000,000 (property) = $1.945M

If Hiring Manager ($60K):

• Adjusted SDE = $315K – $60K = $255K → Value = $765K + property

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9. When to Use Which Metric

Metric	Best For	Typical Multiple
SDE	Owner-operated Main Street biz	2x–3.5x
EBITDA	Larger, manager-run companies	4x–8x
FCF	Buy-and-hold, reinvestment heavy	Variable
Revenue	High-growth or weak books	0.5x–7x
DSCR	Loan approval check	>1.25 ratio

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10. Learning Points

• SDE = “How much I make if I run it myself.”

• EBITDA = “How much the business makes if I hire a manager.”

• FCF = “How much cash is truly left to use.”

• Net Income = “What the accountant says we made (but doesn’t tell the full story).”

• Real Estate = “Adds stability, bank financing, and appreciation — value it separately.”