Sum-of-the-Parts (SOTP) Valuation: A guide for your financial planning

Sum-of-the-Parts (SOTP) is a valuation method that involves valuing each business segment or subsidiary of a company separately and then adding up the values to determine the total value of the entire company. It is especially useful for companies that operate in multiple distinct sectors or have various business units that are unrelated to each other.

In this guide, we will explain the Sum-of-the-Parts (SOTP) valuation method, walk through its components, provide an example, and highlight when and why this approach is used. This method is often used in corporate finance, mergers and acquisitions (M&A), and investment analysis when a company’s diverse operations or subsidiaries are not easily valued using traditional methods like Discounted Cash Flow (DCF).

What is Sum-of-the-Parts (SOTP) Valuation?

Sum-of-the-Parts (SOTP) is a method used to value a company by determining the value of each of its separate business units or divisions. Instead of using a single valuation approach for the entire company, SOTP applies different valuation methods for each unit or segment based on the nature of the business. These individual values are then summed up to arrive at the company’s total value.

The SOTP method is particularly useful for conglomerates or companies with diversified business lines, such as those operating in multiple industries (e.g., technology, consumer goods, and energy). Each unit or subsidiary may have different financial metrics, growth rates, and risk profiles, which is why a segmented valuation approach is needed.

How Does SOTP Work?

The SOTP method can be broken down into several key steps:

1. Identify and Segregate Business Units or Segments

• The first step in conducting a SOTP valuation is to break down the company into its individual business units, divisions, or subsidiaries.
• Each unit should operate in a distinct industry or market and may have different growth profiles, risk levels, and revenue streams.

Example: Let’s say ABC Corporation has three business units:

• Unit 1: Consumer Goods
• Unit 2: Real Estate
• Unit 3: Technology

2. Choose Appropriate Valuation Method for Each Unit

• Once the units are identified, the next step is to choose the best valuation method for each business segment. Common valuation methods include:

  • Comparable Company Analysis (Comps): Used for mature, publicly traded businesses with similar peers.
  • Precedent Transaction Analysis: Used when valuing companies that have been involved in recent mergers or acquisitions.
  • Discounted Cash Flow (DCF): Used for companies or segments with predictable cash flows.
  • Asset-Based Valuation: Used for companies with significant tangible assets or real estate holdings.

• The choice of valuation method depends on the type of business and the availability of data.

3. Perform Valuation for Each Unit

• Calculate the value for each business segment using the chosen valuation method. This could involve calculating the market value of assets, estimating future cash flows, or applying industry-specific multiples.

Example:

• Unit 1 (Consumer Goods): Using P/E ratio and comparable companies, we estimate a value of INR 500 crore.
• Unit 2 (Real Estate): Using asset-based valuation (e.g., NAV – Net Asset Value), we estimate a value of INR 700 crore.
• Unit 3 (Technology): Using DCF analysis, we estimate a value of INR 300 crore.

4. Add the Values Together

• After calculating the value of each business unit or subsidiary, the next step is to sum these values to arrive at the total value of the company.

Example:

• Total Value of ABC Corporation = Value of Unit 1 + Value of Unit 2 + Value of Unit 3
• Total Value = INR 500 crore + INR 700 crore + INR 300 crore = INR 1,500 crore

5. Adjust for Debt and Cash

• After summing the values of the individual units, adjust for the company’s debt and cash. Subtract the company’s outstanding debt and add any excess cash to arrive at the final enterprise value (EV).

Example:

• Debt = INR 200 crore
• Cash = INR 100 crore
• Adjusted Total Value = INR 1,500 crore - INR 200 crore + INR 100 crore = INR 1,400 crore

Why Use SOTP Valuation?

Sum-of-the-Parts (SOTP) valuation is particularly useful in situations where:

1. The Company is a Conglomerate: SOTP is ideal for companies with diverse operations that span across multiple industries. For example, a conglomerate like Berkshire Hathaway operates in industries ranging from insurance to energy and consumer goods. Each unit may require a different valuation approach based on its industry and business model.
2. The Company Has Multiple Subsidiaries or Divisions: If a company has several subsidiaries or divisions that operate independently or in unrelated industries, SOTP helps provide a more accurate valuation by considering the value of each business unit separately.
3. The Business Units Have Different Growth Rates or Risk Profiles: For companies with units that have differing growth potential, profitability, or risk, SOTP provides a more tailored approach to valuation by applying different valuation methods to each unit.
4. M&A or Restructuring Scenarios: SOTP is commonly used in mergers and acquisitions (M&A), where companies with multiple segments may sell off certain divisions. It helps to estimate the value of individual parts of the company before making a decision on an acquisition or divestiture.

Advantages of SOTP Valuation

1. Segmented View: SOTP gives investors a more detailed, segment-by-segment breakdown of a company’s value, which allows for better insights into individual business units' strengths and weaknesses.
2. Appropriate for Complex Companies: For large, diversified companies, SOTP provides a more accurate estimate of value than other methods because it accounts for the varying risk, growth rates, and capital structures of different business units.
3. Flexibility in Valuation Method: SOTP allows for using different valuation methods for different segments of the company, making it adaptable to a variety of business types and industries.

Limitations of SOTP Valuation

1. Data Availability: To apply SOTP effectively, you need access to accurate and detailed financial data for each business unit. For privately held companies or subsidiaries, data may not always be available.
2. Difficulty in Selecting Comparable Companies: Choosing appropriate comparable companies for each business unit can be challenging, especially if the segments are highly specialized or operate in niche markets.
3. Complexity in Execution: SOTP requires significant time and effort to value each business segment separately and then consolidate the results. It also requires making several assumptions about the future growth and risk of each unit.
4. Risk of Over-Simplification: In some cases, SOTP can oversimplify the valuation by breaking down the company into separate parts without considering the synergies between the business units. For example, a company may be worth more than the sum of its parts if its business units work together effectively.

Real-World Example: SOTP Valuation of Reliance Industries

Let’s consider Reliance Industries, a conglomerate that operates in various industries such as energy, retail, telecommunications, and media. To value Reliance Industries using the SOTP method:

Step 1: Identify Business Segments

• Energy: Includes refining, petrochemicals, and exploration.
• Retail: Operates a chain of retail stores and e-commerce platforms.
• Telecommunications: Includes Jio, its telecom arm.
• Media: Includes broadcast and digital media businesses.

Step 2: Select Valuation Methods for Each Segment

• Energy: Use EV/EBITDA multiples of comparable companies in the energy sector.
• Retail: Use P/S Ratio based on similar retail companies.
• Telecommunications: Use EV/EBITDA or P/E Ratio of telecom peers.
• Media: Use P/E ratio based on the media sector.

Step 3: Perform the Valuation

• For each segment, calculate the value using the appropriate method.

Step 4: Add Up the Values

• Add the individual values of each segment.

Step 5: Adjust for Debt and Cash

• Subtract any corporate debt and add any cash to arrive at the final total value.

Happy investing!