The SDE (Seller's Discretionary Earnings) method isn't inherently "bad" for manufacturing business valuations, but there are complexities and nuances associated with manufacturing businesses that can make SDE less ideal in certain scenarios. Here are some reasons why SDE might be less preferred or require careful adjustments when valuing a manufacturing business:
Relevant Templates:
Capital Intensive: Manufacturing businesses are often capital-intensive, which means they have significant investments in machinery, equipment, and infrastructure. Since SDE doesn't account for depreciation (a significant expense for capital-intensive businesses), using SDE without adjustments may overstate the profitability of the business.
Inventory Complexity: Manufacturing businesses can have complex inventory systems with raw materials, work-in-progress, and finished goods. If not accounted for properly, the valuation may not reflect the true economic picture.
Owner's Role: SDE typically adds back the owner's salary to reflect the true earnings available to a potential owner. However, if the manufacturing business is large and the owner plays more of a passive investor role rather than an active management role, this adjustment might overstate the earnings.
Volatility in Costs: Manufacturing businesses can face volatility in input costs, such as raw materials. If these are not accounted for appropriately, the SDE might not give a consistent view of the business's earnings.
Scale of Operations: Larger manufacturing businesses might be more akin to mid-sized or even larger corporations, making EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) a more appropriate metric.
Multiple Owners or Managers: If a manufacturing business has multiple owners, partners, or high-paid managers, the calculation of SDE can become complicated, and the resulting figure may not provide a clear picture of the business's discretionary earnings.
Growth and Investment: Manufacturing businesses might reinvest a significant portion of their earnings for expansion, research, and development. SDE might not capture the future potential or the reinvestment needs of the business.
Leverage and Debt: If a manufacturing business is heavily leveraged, the interest costs become a significant factor. Since SDE does not account for interest expenses, it might not reflect the true discretionary earnings after such costs.
However, this doesn't mean SDE can't be used for manufacturing businesses at all. For smaller, owner-operated manufacturing firms, SDE can still provide valuable insights. But it's crucial to make the necessary adjustments and to consider the business's specific circumstances. In many cases, especially for larger manufacturing entities, EBITDA or other valuation metrics may provide a clearer picture.
Article found in Valuation.
