Understanding EBITDA, Adjusted EBITDA, and SDE in Business Valuations

When valuing a business, one of the most important questions is: how much money does the business really make? The answer depends on how earnings are measured. Several financial metrics are commonly used in valuation, including EBITDA, Adjusted EBITDA, Seller’s Discretionary Earnings (SDE), and Maintainable Earnings. Each of these terms reflects a different approach to understanding profitability and serves a different purpose.

This article explains what each term means, how they differ, and why it matters when valuing a small or mid-sized business. We’ll also work through a real-world example to show how normalizing owner compensation and one-time items can significantly impact the earnings used in a valuation.

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EBITDA: The Starting Point

EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortization. It’s a widely accepted measure of a company’s operational performance, removing accounting and financing factors that may vary from one business to another. EBITDA allows investors or buyers to compare companies more easily by focusing strictly on their core profitability.

While useful, EBITDA is a raw figure. It doesn’t account for owner-specific decisions, unusual events, or non-operating costs that might distort what the business can earn on an ongoing basis.

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Adjusted EBITDA: A Clearer Picture

Adjusted EBITDA goes a step further by removing one-time, discretionary, or non-operational items to reflect a more normalized view of earnings. This is often used in mergers and acquisitions or bank financing situations, where the goal is to isolate earnings that are likely to continue under new ownership.

Common adjustments include:

• Salaries paid to owners or family members above or below market value.
• Personal expenses run through the company (e.g., personal vehicle, travel, or phone bills).
• One-time, non-recurring expenses like major legal fees or restructuring costs.
• One-time revenue events, such as the sale of an asset or government relief funds.
• Rent paid above or below market rates to a property owned by the business owner.

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Seller’s Discretionary Earnings (SDE): For Owner-Operators

SDE is tailored to small businesses where a single owner is actively involved in the day-to-day operations. It represents the total financial benefit an owner derives from the business. A common point of confusion is why the owner's salary is added back, since a new owner will also need to draw a salary. The reason is that SDE is designed to show the total pool of cash flow available to a single new owner before they pay themselves. The new owner can then decide how much to take as a salary and how much to leave as profit. This normalizes the business for comparison, regardless of how the current owner chooses to compensate themself.

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Maintainable Earnings: Looking Ahead

Maintainable Earnings is a normalized estimate of what the business is likely to earn on a sustainable basis going forward. It is typically based on historical performance, adjusted for anomalies and any known changes to cost structure or revenue. This metric is often used when applying valuation multiples and is especially useful for buyers and lenders trying to forecast future cash flow. In most cases, it will be a weighted average of Adjusted EBITDA.

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SDE vs. Adjusted EBITDA: Which Metric Should You Use?

The choice between SDE and Adjusted EBITDA largely depends on the size of the business and the likely buyer.

• SDE is typically used for smaller, owner-operated businesses (often those with earnings under $1 million) where the buyer is an individual who plans to manage the company themselves.
• Adjusted EBITDA is the standard for larger businesses that are likely to be acquired by a private equity firm, a strategic competitor, or an investor who will hire a professional manager to run the company.

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Real-World Example: Normalizing for Family Compensation and One-Time Events

To see how these metrics work, let’s walk through a valuation scenario for a small managed IT service company.

The financial statements show the following:

• The owner pays themselves a salary of $120,000 to act as general manager. A professional valuator determines the market rate for this role (based on industry surveys and job market data) is $100,000.
• The owner’s spouse is paid $70,000 for bookkeeping duties that would normally cost about $80,000 if outsourced.
• Their adult child is paid $50,000 but does not actively work in the business.
• The company incurred a one-time legal expense of $15,000 related to a contract dispute.
• The company recorded $25,000 in COVID-related government loan forgiveness.

Let’s assume the business had the following reported earnings:

• Net Income: $75,000
• Depreciation & Amortization: $20,000
• Interest: $5,000
• Taxes: $10,000

Here’s how each metric would be calculated:

EBITDA: Starting with reported earnings: EBITDA = Net Income + Interest + Taxes + Depreciation + Amortization EBITDA = $75,000 + $5,000 + $10,000 + $20,000 = $110,000

This gives us a base figure, but it still includes all the owner and family salaries and unusual income/expenses.

Adjusted EBITDA: Here, we normalize EBITDA for all non-operational or non-recurring items to reflect profitability under a professional manager.

• Start with EBITDA: $110,000
• Add back owner's excess salary: + $20,000 ($120,000 paid vs. $100,000 market rate)
• Adjust for spouse's underpaid salary: - $10,000 (Market rate is $80,000, but only $70,000 was expensed)
• Add back child’s non-working salary: + $50,000
• Add back one-time legal fees: + $15,000
• Subtract non-recurring government relief: - $25,000
• Adjusted EBITDA = $160,000

This represents the company’s normalized profitability if it were run by a typical management structure.

Seller’s Discretionary Earnings (SDE): SDE shows the total potential income for a single owner-operator. The standard calculation builds from pre-tax profit and adds back all owner-related and discretionary items.

• Start with Pre-Tax Income: $75,000 (Net Income) + $10,000 (Taxes) = $85,000
• Add back Interest, Depreciation & Amortization: + $5,000 (Interest) + $20,000 (D&A) = $110,000
• Add back Owner's Full Salary: + $120,000
• Add back all other discretionary/non-recurring expenses:
  
  • + $70,000 (Spouse's Salary)
  • + $50,000 (Child's Salary)
  • + $15,000 (One-time Legal Fee)
• Subtract non-recurring income: - $25,000 (Government Relief)
• SDE = $340,000

This figure represents the total financial benefit available to a single owner-operator.

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Why These Differences Matter

As you can see, each metric paints a different picture of profitability:

• EBITDA: $110,000
• Adjusted EBITDA: $160,000
• SDE: $340,000

The difference between $110,000 (EBITDA) and $340,000 (SDE) is substantial. Choosing the right earnings metric is crucial because this figure is the foundation of the final valuation. An estimated business value is typically calculated by applying a valuation multiple (e.g., 3x, 4x, 5x) to the normalized earnings figure. Using the wrong earnings base can lead to a wildly inaccurate valuation.

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Getting the Numbers Right

Understanding and applying the correct earnings metric is essential for producing an accurate and defensible valuation. Whether you’re planning to sell, preparing for succession, or simply want to understand what your business is worth, normalizing your earnings properly makes all the difference.

At Flux Valuations, we specialize in helping Canadian business owners uncover the real value of their business with clear, data-driven insights tailored to their goals.