What Is Sum-of-the-Parts Valuation? Explained, Examples, and Applications
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Summary:
The sum-of-the-parts valuation (SOTP) is a process of valuing a company by determining what its aggregate divisions would be worth if they were spun off or acquired by another company. This valuation provides a range of values for a company’s equity by aggregating the standalone value of each of its business units and arriving at a single total enterprise value (TEV). The equity value is then derived by adjusting the company’s net debt and other non-operating assets and expenses.
What is sum-of-the-parts valuation – SOTP?
The sum-of-the-parts valuation, often abbreviated as SOTP, is a financial process used to determine the value of a company by assessing what its individual divisions would be worth if they were spun off or acquired by other entities. This valuation method provides a range of values for a company’s equity by aggregating the standalone value of each of its business units and arriving at a single total enterprise value (TEV). The equity value is then derived by adjusting the company’s net debt and other non-operating assets and expenses.
The formula for sum-of-the-parts valuation – SOTP
The SOTP formula is as follows:
SOTP = Value of first segment + Value of second segment + … + Value of Nth segment – Net debt + Nonoperating assets – Nonoperating liabilities
The value of each business unit or segment is derived separately, and various methods can be employed to determine their worth, including discounted cash flow (DCF) valuations, asset-based valuations, and multiples valuations based on revenue, operating profit, or profit margins.
How to calculate sum-of-the-parts valuation – SOTP
To calculate the SOTP valuation, the worth of each business unit or segment is determined individually. This can be done using a variety of analysis methods, including:
- Discounted cash flow (DCF) valuations
- Asset-based valuations
- Multiples valuations using revenue, operating profit, or profit margins
What does the SOTP tell you?
The sum-of-the-parts valuation, also known as breakup value analysis, helps a company understand its true value. In cases where a company is “worth more than the sum of its parts,” it implies that the value of the company’s divisions could be higher if they were sold to other companies.
Larger companies can often exploit synergies and economies of scale unavailable to smaller companies, which enables them to maximize a division’s profitability and unlock unrealized value. SOTP valuation is especially useful when a company consists of business units in different industries, as valuation methods vary across industries depending on the nature of revenue. It can be employed to defend against hostile takeovers or during a company’s revaluation after a restructuring.
Example of how to use the sum-of-the-parts valuation – SOTP
Let’s illustrate the SOTP valuation with an example:
Consider United Technologies (NYSE: UTX), which announced its intention to break the company into three units in late 2018—an aerospace, elevator, and building systems company. By using the 10-year median enterprise value-to-EBIT (EV/EBIT) multiple for peers and 2019 operating profit projections, the aerospace business was valued at $107 billion, the elevator business at $36 billion, and the building systems business at $52 billion. Thus, the total value is $194 billion. After subtracting net debt and other items of $39 billion, the sum-of-the-parts valuation is $155 billion.
The difference between SOTP and discounted cash flow – DCF
SOTP valuation can incorporate a discounted cash flow (DCF) analysis as part of the process. In contrast, the DCF method values a segment of a company by analyzing the discounted future cash flows. This involves calculating the present value of expected future cash flows, which are then discounted using a predetermined rate.
Frequently asked questions
What is the primary purpose of sum-of-the-parts valuation (SOTP)?
The main purpose of SOTP is to assess the value of a company by evaluating what its individual divisions would be worth if they were separated or acquired by other entities.
When is sum-of-the-parts valuation commonly used?
SOTP valuation is often employed when a company operates as a conglomerate with business units in different industries. It can also be used in scenarios like hostile takeovers and during a company’s revaluation after a restructuring.
How is the value of each business unit determined in SOTP valuation?
The value of each business unit or segment is determined separately and can be calculated using various analysis methods, such as discounted cash flow (DCF) valuations, asset-based valuations, or multiples valuations.
Key takeaways
- Sum-of-the-Parts Valuation (SOTP) assesses the value of a company by determining what its individual divisions would be worth if separated or acquired by other entities.
- SOTP helps companies understand their true value, particularly in situations like hostile takeovers and restructuring.
- This valuation is commonly used by conglomerates with business units in different industries.
- It can incorporate methods like discounted cash flow (DCF) and is distinct from DCF valuations.
- Limitations include complexity with multiple segments and not accounting for tax implications in spinoffs.
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