Understand Sum of Parts valuation (SOTP) in detail

If you want to understand as to new is the process of the sum of parts valuation method works then you are at the right place because we will help you in understanding its relevance, limitations, procedures, & whatnot. So, let’s quickly understand it in detail.

What is Sum of Parts Valuation (SOTP) valuation ?

The sum of parts valuation also known as SOTP is a method that is used to value a firm by separately ascertaining the value of each business segment/ asset and then adding them up to obtain the total value of the firm also known as deriving the single Total Enterprise Value (TEV). 

The equity value of the firm is then arrived at by adjusting the non-performing assets, expenses and the net debt of the firm. This method of the SOTP can be used along with the methods of discounted cash flow modelling and comparable company analysis.

How It Works

1. Segmentation: The company is divided into its core business units or subsidiaries, each representing a different line of business. Example: For ITC Ltd., segments include Cigarettes, Hotels, Paperboards, Packaging, Agri-Business, Packaged Foods, Information Technology, Branded Apparel, Personal Care and others.
2. Individual Valuation: Each segment is valued independently using appropriate valuation methods such as Discounted Cash Flow (DCF), Comparable Company Analysis, Asset-Based Valuations or Market Multiples. Example: Valuing ITC’s Cigarette segment might use EV/EBITDA multiples common in the tobacco industry, while the Hotels segment could be valued using revenue multiples specific to the hospitality sector. 
3. Aggregation: The individual valuations are summed to arrive at the total enterprise value (TEV) of the entire company. Calculation: TEV = ∑Value of Each Segment. 
4. Adjustments: Net debt and any non-operating assets or liabilities are subtracted to determine the final equity value. Example: If the company holds excess cash or has investments unrelated to its main business segments, these should be adjusted accordingly.
5. Equity Value Per Share:
   Calculate Equity Value: After adjustments, the resulting figure represents the equity value attributable to shareholders.
   Determine Per Share Value: Divide the total equity value by the number of outstanding shares to get the SOTP-derived share price.
   Share Price=Equity Value/Total Shares Outstanding.
   Compare with Market Price: Assess whether the shares are undervalued, overvalued or fairly valued by comparing the SOTP share price with the current market price.
6. Sensitivity Analysis:
   Test Assumptions: Perform sensitivity analysis to understand how changes in key assumptions (e.g., growth rates, discount rates, multiples) impact the overall valuation.
   
   Scenario Planning: Evaluate different scenarios (optimistic, pessimistic, base case) to gauge the range of possible valuations.
7. Documentation and Presentation:
   Organize the Model: Ensure that the valuation model is well-structured, with clear documentation of assumptions, methodologies,and sources of data.
   
   Visual Aids: Use charts, graphs and tables to present the valuation results in an easily understandable format.

Example of the Sum of Parts Valuation (SOTP)

For instance: if a company Trump Limited has diversified segments then the value of all the segments is required to be counted to arrive at the true valuation of the company.

Cases where the Sum of Parts Valuation (SOTP) can be used

The importance of the SOTP method has been discussed that how much it is essential for the business to have, there are some scenarios/transactions where this method can be proven to be useful. There are as follows:

• Conglomerate: A conglomerate is a situation where a firm is working in more than one industry & this is why it becomes essential to analyze different segments as the risk/return profile is different & varies from segment to segment.
  
  Apart from the conglomerates, this can prove to be beneficial for the companies that report different business segments or divisions or companies having different assets or the situations that require a higher level of detail such as building a financial model for acquisition.

• Restructuring: Restructuring is a scenario condition that is performed in the case that any of the segments is underperforming then in such a scenario the ideal situation would be restructuring and selling off the non-performing segment to increase the liquidity of the organization.

• Spin-off: spin-off is a situation where the parent company issues a certain amount of shares to create a subsidiary, therefore, it is imperative to assess if the subsidiary is of more value in comparison to the whole or the whole is of more value.
  
  If the subsidiary is more beneficial then creating it and spinning it off will be beneficial and vice-versa.
• Mergers and Acquisitions: Helps potential buyers assess the value of each division they are interested in acquiring.
• Investment Analysis: Investors use SOTP to uncover hidden values within a company, especially when the market undervalues certain segments.
  
  By understanding the value of each part, investors can make more informed decisions about buying, holding or selling shares.
• Regulatory and Compliance Reasons: In some cases, regulatory bodies may require detailed valuations of different business units, especially in industries like banking and insurance where different segments have distinct risk profiles.

Examples

• ITC Ltd.: An Indian conglomerate with diverse operations in cigarettes, hotels, paperboards and FMCG products uses SOTP to evaluate each segment’s contribution to the overall value.
• Berkshire Hathaway: With its vast array of subsidiaries across various industries, SOTP helps in understanding the collective worth of its holdings.

The Sum of the Parts Valuation (SOTP) cannot be used for?

• Companies having a single line of business
• In the case of a less detailed and simple model is required
• Companies that do not disclose any segments and their information cannot be found.

Limitation of Sum of the Parts Valuation (SOTP) valuation

As every coin has two sides and we have already discussed the importance of the SOTP so let’s quickly go through with the limitations of it.

• Treatment of different synergies: the treatment of different synergies became extremely difficult in the case of different divisions. These synergies can include cost savings that are difficult to bifurcate or distribute among different segments.

• Relying upon the broad assumptions: relying upon the broad assumptions can prove to be detrimental as the output received by these results is not accurate and at the same time less credible.

• Limited data: the SOTP valuations seem to be fundamentally sound, the limited amount of publicly available segment-level data can prove to be a major drawback in assessing and building a complete SOTP value for each segment.

Performing the Sum of the Parts Valuation (SOTP)

The Sum of the Parts Valuation (SOTP) is considered the most important tool for valuing companies having or possessing multiple segments that are different from each other from the return/risk point of view.

If a company chooses to value the company by using the discounted cash now analysis method then each of the segments will use a different discount rate & this means that the expected returns of each segment will be different.

On the other hand, if the SOTP valuation is done using multiple analyses via comparable company analysis or precedent transactions then it will be quite a difficult & tedious task to determine a single appropriate transaction or the trading multiple.

Where the Discounted Cash Flow approach is to be used for SOTP?

In the case of the companies that are working in the industry of automobiles, gas, oil, software and e-commerce. However, the valuation of the banks is performed using the relative valuation approach or the residual income method.

Where the Relative Valuation Approach is to be used for SOTP?

As we have already discussed this method will be more suited to the banks and in the case of an e-commerce that is not yielding more results using this approach would be futile. Therefore, it is essential that a single valuation technique should be used to value different segments in accordance with the requirements of their industry.

The process of the Sum of Parts Valuation (SOTP) Method Structure

In order to perform the sum of parts (SOTP) valuation it is imperative to follow the below-mentioned steps:

• Identifying the Business Segments: Identifying Appropriate Business segments on which the valuation is to be performed.
• Performing Valuation of the Segments: Performing stand-alone valuation of each segment by using the appropriate valuation technique.
• Obtaining the Total Enterprise Value: Adding the calculated valuations for the Total Enterprise Value
• Obtaining the Implied Equity Value: Subtracting the net debt and non-operating items from the total enterprise value. The amount that is obtained is the Implied Equity Value 
• Obtaining the SOTP value of the shares: Dividing the implied equity value by the (total number of outstanding shares) the SOTP value of the share prices can be reached. This will then be compared to the current pricing in the open market to determine if the shares are fairly valued undervalued or overvalued.

The formula for the Sum of the Parts Valuation (SOTP)

SOTP = N1 + N2 +… + ND- NL + NA

Where:

N 1= value of the first segment

N2 = value of second segment

ND = net debt

NL = non-operating liabilities

NA = non-operating assets

Valuation Techniques for Each Segment

When performing a Sum of Parts (SOTP) valuation, choosing the appropriate valuation technique for each business segment is critical, as different industries require different methods due to their unique financial metrics. Below are common methods used to value different types of business units:

1. Discounted Cash Flow (DCF)

• When to Use: DCF is ideal for segments with predictable and stable cash flows, such as manufacturing, utilities or technology companies with mature products. It discounts future free cash flows back to present value using an appropriate discount rate that reflects the segment’s risk.
• Example: In the case of Amazon, its cloud computing division (AWS) could be valued using DCF due to its stable and predictable growth trajectory.

2. Comparable Company Analysis (Comps)

• When to Use: This approach is suitable for companies in industries where there are established competitors, like retail, tech and healthcare. Analysts use multiples like EV/EBITDA, EV/Sales or P/E ratios to benchmark the company’s segments against similar public companies.
• Example: For a conglomerate like General Electric (GE), its healthcare division could be valued using EV/EBITDA multiples based on comparable companies in the medical devices industry.

3. Market Multiples

• When to Use: Multiples are useful for quick valuation estimates, often applied to unprofitable segments where traditional metrics like net income or operating profits are not available.
• Example: For an e-commerce company with high growth but low profitability, like the e-commerce division of a conglomerate, EV/Sales or EV/Subscriber multiples may be used.

4. Asset-Based Valuation

• When to Use: This method is applicable to industries where tangible assets are key drivers of value, such as real estate, mining or heavy manufacturing. The value is derived from the market or replacement value of the assets.
• Example: The oil and gas segment of a conglomerate could be valued based on the value of reserves using EV/boe (Enterprise Value per barrel of oil equivalent).

By applying different methods tailored to each segment’s characteristics, the SOTP approach ensures that the valuation reflects the true nature of each division’s performance and future potential.

Advantages and Limitations of SOTP Valuation

Advantages

1. Granular Insights: SOTP provides a detailed look into each business unit, allowing investors and analysts to see where value is being created or destroyed. By separating divisions, SOTP uncovers hidden value within the conglomerate that a standard valuation might overlook.
2. Strategic Decision-Making: This approach is invaluable for companies considering spin-offs, mergers or divestitures. It allows firms to evaluate the worth of each division and decide whether divesting or retaining certain business units will maximize shareholder value.
3. Accurate Valuation for Diverse Businesses: SOTP is especially useful for conglomerates operating across industries with varying risk profiles and growth trajectories. A single valuation metric may not work for all divisions, but SOTP’s flexibility enables precise valuation.
4. Hostile Takeover Defense: SOTP can be used to defend against hostile takeovers by proving that the sum of the company’s parts is worth more than the current market value.

Limitations

1. Complexity: SOTP can be time-consuming and difficult to implement. Analysts must gather detailed financial data for each division and apply the appropriate valuation method, which can be labour-intensive.
2. Subjectivity: The choice of multiples, discount rates and growth assumptions can vary significantly depending on the analyst’s perspective, leading to subjectivity in the final valuation.
3. Inconsistent Comparables: Finding comparable companies for each segment can be challenging, especially if the conglomerate operates in niche markets. Without appropriate benchmarks, the valuation might be skewed.
4. Overemphasis on Parts: Focusing too much on the individual components may overlook synergies between divisions that add to the company’s overall value.

Despite these limitations, SOTP remains a powerful tool for valuing complex, multi-segmented companies, especially when detailed analysis is required for strategic decisions.

Real-Life Applications of SOTP

1. Mergers and Acquisitions (M&A)

SOTP is frequently employed in M&A activities to determine the fair value of a target company’s various divisions. Buyers often focus on acquiring specific segments of a conglomerate, rather than the entire business.

For example, when United Technologies (UTX) announced plans to break up its business into separate entities focused on aviation, elevators and building systems, SOTP analysis was used to evaluate each division independently.

2. Corporate Spin-Offs

In corporate spin-offs, SOTP helps determine whether individual segments will be more valuable as standalone entities or as part of the parent company.

For instance, General Electric (GE) has spun off several divisions over the years, such as its financial services arm, to unlock value that was not fully recognized when all divisions were bundled together.

3. Private Equity Investments

Private equity firms often use SOTP to identify underperforming divisions within a larger company that could be restructured or sold at a premium. By valuing each segment independently, they can spot opportunities for growth and acquisition.

4. Biotechnology Valuations

SOTP is also common in the biotech sector, where companies often have a pipeline of products at various stages of development. Each drug or product line has a different risk profile and potential market value. By valuing each segment separately, analysts can provide a more accurate reflection of the company’s potential future value.

5. Hostile Takeover Defense

Companies facing hostile takeovers can use SOTP to demonstrate that their stock is undervalued. By presenting a detailed valuation of each division, management can prove that the company’s breakup value exceeds its current market valuation, making it less attractive to potential acquirers.

6. Conglomerates with Diverse Divisions

One of the best-known examples of SOTP application is Berkshire Hathaway, which owns a wide range of businesses from insurance to railroads and energy.

SOTP helps analysts value each division based on its industry-specific metrics and aggregate the results for a more accurate company valuation.

Example of SOTP Valuation – ITC Case Study

To demonstrate how Sum of Parts (SOTP) valuation is applied in practice, let’s look at a real-world example using ITC Ltd., an Indian conglomerate with diverse businesses. ITC operates in industries such as cigarettes, hotels, packaged foods, agriculture, paperboards and personal care.

Since each of these segments operates in different markets and under unique conditions, valuing ITC as a single entity would obscure the distinct value each business unit contributes to the overall company.

Step 1: Identify the Key Segments

The first step in the SOTP process is to break down ITC into its core segments:

• Cigarettes: ITC’s traditional and most profitable business.
• Hotels: A rapidly growing, though smaller, division.
• FMCG & Packaged Foods: An emerging sector that is gaining market share.
• Agri-Business: Contributes to ITC’s supply chain and exports.
• Paperboards & Packaging: A steady revenue generator with strong market leadership.

Step 2: Valuing Each Segment

Each of ITC’s segments is valued using different methods based on their financial characteristics:

• Cigarettes: As ITC holds a dominant position in the market, the cigarettes business is valued using EV/EBITDA multiples commonly applied to tobacco companies, as these reflect profitability more accurately.
• Hotels: The hospitality sector is valued using EV/Revenue multiples, which are suitable for asset-heavy industries like hotels where profit margins may fluctuate.
• FMCG & Packaged Foods: This emerging segment is valued using Price-to-Sales multiples due to its growth potential and lower current profitability compared to established players.
• Agri-Business: Given that it is heavily export-oriented, this segment is valued using a combination of DCF and comparable company analysis, factoring in both revenue forecasts and industry benchmarks.

Step 3: Summing the Parts

Once each segment’s value is calculated, they are summed to determine ITC’s total enterprise value (TEV). The aggregation of these individually valued parts gives a clearer picture of the company’s overall worth than a single valuation approach might.

Step 4: Adjusting for Debt and Non-Core Assets

After deriving the total value of all segments, adjustments are made for ITC’s net debt and any non-core assets or liabilities. This ensures that the final equity value reflects the true value available to shareholders.

SOTP in Financial Modeling

When building a financial model using the Sum of Parts approach, the structure and organization of the model are crucial. A well-built SOTP model enables clear visibility of each business segment and ensures that the overall valuation remains accurate and intuitive. Below is a structured approach for setting up an SOTP model.

1. Segment-Level Financial Models

Each business segment must have its own distinct financial model, complete with assumptions for revenue, costs and growth rates:

• Revenue and Cost Drivers: For each segment, identify the unique factors that drive revenue and costs. For example, the cigarettes division of ITC might rely on market share and pricing power, while the hotels division might depend on occupancy rates and room pricing.
• EBITDA and Cash Flow Projections: Project EBITDA and free cash flows for each segment, considering its specific market conditions.

2. Assign Valuation Multiples

Each business segment will likely require different valuation multiples:

• EV/EBITDA or P/E ratios for mature businesses like cigarettes.
• Price-to-Sales or EV/Sales for growth businesses like FMCG. These multiples are derived by comparing each business unit with similar companies in the industry (comparable company analysis).

3. Consolidation

Once each segment’s valuation is completed, consolidate the values by summing them up to create a total enterprise value (TEV) for the entire company. This step might also include adjustments for minority interests if the company does not fully own a business unit.

4. Adjust for Debt and Non-Operating Items

After summing the individual valuations, subtract net debt and adjust for non-operating assets or liabilities. These adjustments ensure the model reflects the equity value attributable to the shareholders.

5. Scenario and Sensitivity Analysis

Given the variability in assumptions, it is vital to conduct sensitivity analysis on key inputs like discount rates, growth rates and multiples. This helps to understand how changes in assumptions will affect the overall valuation and allows analysts to provide a range of potential outcomes (optimistic, base and pessimistic scenarios).

SOTP and the Diversification Discount

Diversification discount also known as the conglomerate discount is accused while valuing a company using the SOTP approach. Diversification discounts may range from 10% to 30%, however, it range and varies from country to country.

The difference between SOTP and Discounted Cash Flow

These both are the valuation methods and the SOTP may incorporate the discounted cash flow approach though DCF uses the discounted future cash flows to value the business or project or any segments.

Conclusion

SOTP is the process of individually evaluating the divisions of the company to confirm of these are worth if they were spun off or bought by a different company. This approach enables a company to establish a useful measure of the value as it will be helpful in the case of a hostile takeover or restructuring.

Frequently Asked Questions on Sum of Parts Valuation (SOTP)

Q1. What is the sum of parts enterprise value?

Ans 1. The sum of parts enterprise value is the summing of the individual business assets to arrive at the total enterprise value

Q2. What is the SOTP valuation method?

Ans 2. The SOTP valuation method is the process of valuing a company by determining the worth of individual assets if it has been acquired by another company.

Q3. What is the PV formula for valuation?

Ans 3. The formula of PV in valuation is pv=fv/(1+r/n) nt

Q4. What is the form for valuation?

Ans 4. The formula for valuation is valuation = Share Price * Total Number of shares.

Q 5. What is the formula for Enterprise value valuation?

Ans 5. The formula for enterprise value Valuation is the sum of the market value of the equity along with the market value of the company debts minus my cash

Q6. What is the formula for enterprise value in DCF?

Ans 6. The formula for enterprise value in DCF is EV = (share price X number of shares) + total debt – cash

Q 7. What is the formula for breakup value?

Ans 7. The breakup value can be ascertained by calculating the total assets of each business unit minus its liabilities.

Q 8. Why do we calculate pv?

Ans 8. PV is calculated because it gives the idea of what assets & companies are and what are not.

Q9. What is the formula for EV EBITDA?

Ans 9. The formula for EV EBITDA → EBIT + d and a

Q10. What is the value of PV?

Ans 10. Present value also known as PV is the current value of the future sum of money.

Q11. When should the SOTP valuation method be used?

Ans11. SOTP is best used for conglomerates or companies with multiple distinct business units, especially when each unit operates in different industries or markets. It’s also valuable during mergers, acquisitions, restructuring or spin-offs to get a detailed view of individual segment performance.

Q12. How do you perform a Sum of Parts (SOTP) valuation?

Ans12. To perform a SOTP valuation, follow these steps:

1. Identify and separate the company’s key business units.
2. Select the appropriate valuation method for each segment (e.g., DCF, Comparable Company Analysis).
3. Sum the individual valuations to get the total enterprise value (TEV).
4. Adjust for net debt and non-operating items to arrive at the final equity value.

Q13. What are the main advantages of using SOTP valuation?

Ans13. The main advantages of SOTP include:

• Revealing hidden value in underappreciated segments.
• Providing a more accurate valuation for diversified businesses.
• Supporting strategic decisions like spin-offs, mergers or divestitures by understanding individual segment performance.

Q14. What are the limitations of Sum of Parts (SOTP) valuation?

Ans14. The limitations include:

• High complexity due to the need for separate valuations for each business unit.
• Subjectivity in selecting valuation methods and assumptions for each segment.

Potential difficulty in finding appropriate comparable companies for niche markets.

Q15. Can SOTP valuation help in defending against a hostile takeover?

Ans15. Yes, companies can use SOTP valuation to demonstrate that their stock is undervalued. By showing that the sum of the company’s individual parts is worth more than the current market value, it can discourage hostile takeovers.

Q16. What is the difference between SOTP valuation and traditional company valuation?

Ans16. Traditional valuation methods assess a company as a whole using metrics like overall cash flows or profits, while SOTP values each business segment independently, providing a more granular and often more accurate estimate for multi-segment businesses.

Q17. What are common industries where SOTP is applied?

Ans17. SOTP is commonly applied in industries with diversified businesses, such as conglomerates, biotechnology (for different drug pipelines), real estate (across multiple properties) and private equity portfolios.

Q18. How does SOTP help in Mergers and Acquisitions (M&A)?

Ans18. In M&A, SOTP valuation helps both buyers and sellers evaluate the worth of individual divisions of a company. Buyers can focus on acquiring specific units, while sellers can understand the best way to maximize value by divesting certain segments.

Q19. What are some examples of companies where SOTP valuation is used?

Ans19. Some examples of companies where SOTP is used include General Electric (GE) for its aviation, healthcare and financial services segments and Berkshire Hathaway for its diverse investments across industries like insurance, railroads and energy.