When it’s time to sell your HVAC business, coming up with an accurate valuation can be complicated. There are many factors to consider when calculating an HVAC company valuation. Still, two financial metrics often come into play: EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) and SDE (Seller’s Discretionary Earnings).
Understanding these metrics and knowing which one to use can significantly impact the perceived value of your business. What are the differences between EBITDA and SDE? What are their advantages and disadvantages? Knowing that can help determine which is better for valuing your HVAC business.
Understanding EBITDA
EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortization. It measures a company’s overall financial performance as an alternative to net income.
Calculation of EBITDA:
EBITDA= Net Income+Taxes+Interest Expense+Depreciation and Amortization (D&A) or EBITDA=Operating Income+D&A
EBITDA focuses on a business’s profitability by stripping out the effects of financing, accounting decisions, and tax environments. This makes it a popular metric for larger companies and those looking to benchmark their performance against others in the industry.
Advantages of EBITDA
1. Standardization
EBITDA provides a standardized way to compare businesses, making it easier for investors to evaluate potential acquisitions.
2. Focus on Operations
EBITDA, excluding interest, taxes, depreciation, and amortization, highlights the business’s core operating performance.
3. Valuation Multiples
It is commonly used in valuation multiples (e.g., EV/EBITDA), which are widely understood by investors and industry analysts.
Disadvantages of EBITDA
1. Exclusion of Key Costs
EBITDA doesn’t consider the cost of capital investments, which can be significant for HVAC businesses.
2. Potential for Misleading Results
By ignoring interest and taxes, EBITDA might paint an overly optimistic picture of profitability.
3. Does Not Measure Cash Flow
EBITDA does not calculate capital expenditures or working capital changes, which are important for understanding the business’s cash flow.
Understanding SDE
SDE stands for Seller’s Discretionary Earnings. It measures the total financial benefit that an owner-operator derives from the business.
Calculation of SDE
SDE=Pre-Tax Income (EBT) + Owner’s Salary + Interest Expense, net + Depreciation and Amortization (D&A) + Discretionary Expenses + Non-Recurring Expenses
SDE benefits small businesses and those where the owner plays a significant role in the day-to-day operations.
Advantages of SDE
1. Owner-Centric
SDE reflects the actual economic benefit to the owner, including salary and perks, which is essential for potential buyers who plan to operate the business themselves.
2. Customizable
It can be adjusted to account for one-time and discretionary expenses, providing a more accurate picture of the business’s profitability.
3. Simple to Calculate
SDE is often easier to calculate and understand for small businesses, especially those with straightforward financials.
Disadvantages of SDE
1. Lack of Standardization
SDE is less standardized than EBITDA, making comparing businesses more challenging.
2. Subjectivity
The adjustments made to calculate SDE can be subjective, leading to potential overstatement or understatement of earnings.
3. Limited Appeal to Larger Investors
Larger investors and institutional buyers may prefer EBITDA due to its standardized nature and broader applicability.
Which is Better for Your HVAC Business?
The choice between EBITDA and SDE depends mainly on the size of your HVAC business, the valuation’s intended audience, and the specifics of your business operations.
Use EBITDA if:
- Your Business is Large
Larger HVAC companies, especially those with multiple locations or significant capital investments, might benefit more from EBITDA. It provides a clear picture of operational efficiency, and institutional investors favor it. - You Plan to Sell to Investors or Strategic Buyers
These buyers typically look for standardized metrics to compare potential investments, making EBITDA more appealing. - You Need to Benchmark Against Competitors
EBITDA allows for easier comparison with other businesses in the HVAC industry, which can be helpful in strategic planning and growth.
Use SDE if:
- Your Business is Smaller
Small to mid-sized HVAC businesses with significant owner involvement might find SDE to reflect profitability more accurately. - You Plan to Sell to Individual Buyers
Potential buyers who intend to operate the business themselves will appreciate the insights provided by SDE, including owner benefits and discretionary expenses. - Your Financials Include Many Discretionary Expenses
SDE will provide a clearer picture of the earnings potential if your financial statements have numerous owner-related or non-recurring expenses.
To Summarize
Valuing an HVAC business requires careful consideration of which financial metric to use. EBITDA offers a standardized and operational-focused view suitable for larger companies and institutional investors. In contrast, SDE provides a more personalized and owner-centric perspective, ideal for small businesses and individual buyers. Understanding the strengths and limitations of each metric will help you present the most accurate and appealing valuation of your HVAC business.
Ultimately, whether you choose EBITDA or SDE will depend on your business’s specifics and the nature of your potential buyers. By selecting the right metric, you can ensure a fair and effective valuation process highlighting your HVAC business’s value.
