Table of Contents
- What Is the Sum-of-the-Parts Valuation (SOTP)?
- The SOTP Valuation Formula
- Calculating the Sum-of-the-Parts (SOTP) Valuation
- Insights Gained From the SOTP Valuation
- Practical Example of Applying SOTP Valuation
- Comparing SOTP Valuation with Discounted Cash Flow (DCF)
- Challenges and Limitations of SOTP Valuation
- Expanding Your Knowledge on SOTP Valuation
- The Bottom Line
What Is the Sum-of-the-Parts Valuation (SOTP)?
Let me explain the Sum-of-the-Parts (SOTP) valuation method directly to you. It's a way to value a company's divisions independently and then add them up to find the overall worth. This approach is especially useful for companies with business units in different industries. When you calculate SOTP, you get insights into the standalone value of each division, which helps determine the total enterprise value (TEV) and the company's equity value after adjusting for net debt and non-operating assets.
Key Takeaways
- Sum-of-the-Parts Valuation (SOTP) is a method for assessing a company's value by determining the worth of each individual division if spun off or acquired.
- SOTP is frequently used for conglomerates with diverse business units, allowing for the evaluation of their separate valuations.
- SOTP calculations provide a total enterprise value by combining standalone segment values and adjusting for net debt and non-operating items.
- This valuation can be instrumental in defending against hostile takeovers by demonstrating a higher worth when parts are valued individually.
- The SOTP provides insight into a company's actual value, sometimes revealing that a company's divisions are worth more separately than together.
The SOTP Valuation Formula
Here's the formula you need to know for SOTP: SOTP = N1 + N2 + … + ND - NL + NA, where N1 is the value of the first segment, N2 is the value of the second segment, ND is net debt, NL is nonoperating liabilities, and NA is nonoperating assets. This equation sums up the values of all segments, subtracts liabilities, and adds nonoperating assets to give you the total.
Calculating the Sum-of-the-Parts (SOTP) Valuation
To calculate SOTP, you derive the value of each business unit or segment separately. You can use various analysis methods for this, such as discounted cash flow (DCF) valuations, asset-based valuations, or multiples valuations based on revenue, operating profit, or profit margins. These methods help you assign a fair value to each part of the company.
Insights Gained From the SOTP Valuation
Using sum-of-the-parts valuation, or breakup value analysis, lets you understand a company's true worth. For example, you might find that a tech company is worth more than the sum of its parts, meaning its divisions could be more valuable if sold separately. In other cases, larger companies can leverage synergies and economies of scale that smaller ones can't, which maximizes a division's profitability and unlocks hidden value.
SOTP is often applied to companies with units in various industries, since valuation methods differ by sector. You can use it to fend off a hostile takeover by proving the company is more valuable broken into parts. It's also useful when revaluing a company after restructuring. Remember, sum-of-the-parts valuation is also called breakup value, as it assesses what individual segments would be worth if the company were split up.
Practical Example of Applying SOTP Valuation
Take United Technologies (NYSE: UTX) as an example. In 2018, they announced a split into aerospace, elevator, and building systems units. 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 at $52 billion. That totals $194 billion. After subtracting net debt and other items of $39 billion, the SOTP valuation comes to $155 billion. This shows you how the method works in practice.
Comparing SOTP Valuation with Discounted Cash Flow (DCF)
Both SOTP and discounted cash flow (DCF) are valuation tools, but SOTP can actually include DCF within it. You might value a specific segment using a DCF analysis. DCF itself values a business, project, or segment by discounting expected future cash flows back to their present value using a discount rate. So, they're related, but SOTP is broader for multi-segment companies.
Challenges and Limitations of SOTP Valuation
The SOTP valuation requires valuing multiple business segments, which means dealing with more inputs and potential complexities. Additionally, it doesn't account for tax implications, especially those from a spinoff. You need to be aware of these limitations when applying it.
Expanding Your Knowledge on SOTP Valuation
If you're looking to choose the right valuation tool, check out guides on picking the appropriate valuation method. This can help you decide when SOTP is the best fit.
The Bottom Line
Sum-of-the-Parts Valuation (SOTP) is a solid method for evaluating companies with diverse business units across industries. You calculate each segment's value separately and combine them to find the total enterprise value, making adjustments for net debt, non-operating assets, and liabilities. It's particularly helpful for conglomerates, hostile takeover defenses, or restructurings. However, it involves multiple methodologies and inputs, and it may overlook tax effects from spinoffs. By understanding SOTP, you can gain a clearer picture of a company's real value and make better financial decisions as a business owner or investor.
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