What Does Seller's Discretionary Earnings Mean?
Seller's discretionary earnings is an earnings metric used to value an organization to provide the potential buyers with a more accurate picture of the available cash flow. This metric is more commonly used in the valuation of Main Street organizations rather than middle market ones. The reported earnings for smaller firms are often kept low by the owner for tax purposes. Therefore, discretionary, extraordinary, nonrecurring expenses are added back to show a buyer the true cash flow from operations.
Divestopedia Explains Seller's Discretionary Earnings
The market based valuation of a firm determines the value of a firm by comparing one or more aspects of the target firm with similar aspects of other firms which have an established market value.The valuation of a firm is influenced by variables such as:
- Control issues growth rate, and
- Ease of transfer
Firms in micro-middle market or Main Street generally have discretionary expenses that are not associated with the operations of the firm. Therefore, earnings before interest, taxes, depreciation and amortization (EBITDA) are adjusted and the seller's salary, benefits and perks are added back. The earnings calculated are multiplied by a multiple of discretionary earnings depending on size, perceived risks and so on.
Buyers are interested in the total income available to them. Small firms calculate their revenues and expenses keeping in mind their tax implications. They tend to understate the cash flow from the operations and do not give a fair representation of the financial performance of the firm. Therefore, the net income before deducting the primary owner's benefits, other discretionary, non-operating, nonrecurring expenses is considered for valuation of cash flows.