Valuation is part art, part math, and valuing a company encompasses many different moving parts. Suppose you are valuing a company, and you notice there are several different businesses tied up in the company. How do you value such a company? One of the best ways to value those types of companies is the sum of the parts valuation.
By breaking up the different parts of the business, you can determine which segments offer the most value for the business, but it can also help you determine what segment drives the most value for the business as well.
A company such as Berkshire Hathaway is a sum of parts of many businesses that consist of the operations of Berkshire. It is a sum of the parts of the insurance business, railroads, service, and investments. If you want to get to the bottom of what drives the earnings for Berkshire, it is best to use a sum of the parts valuation.
As you will see through this post, it all sounds scary, but it is quite simple once you understand the process and where to find the different parts to calculate.
In today’s post, we will discover:
- What is the Sum of The Parts Valuation?
- How Do You Value a Business Segment?
- Examples of Sum of The Parts Valuations
- Sum of The Parts Valuation Pros and Cons
Ok, let’s dive in and learn more about the sum of the parts valuation.
What is a Sum of Parts of Valuation?
According to Investopedia:
“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.”
We find the valuation by finding a range of values for the company’s equity by adding the standalone value of each segment of the business and finding a single enterprise value. Then we take that enterprise value and subtract the debt and other non-operating assets and expenses.
So why would we want to value the parts or segments of the businesses separately?
There are three reasons for this type of valuation:
- Liquidation – If you are liquidating your business by selling the assets one at a time, as opposed to the whole business, you would want to value each part individually to know the value of each asset.
- Accounting mission – As both US and international have adopted accounting standards that turn to “fair value” accounting. Accountants have been tasked with redoing balance sheets to show the “fair value” as opposed to book value.
- Sum of Parts – If a business is made up of different parts or assets, you may want to value each part individually for several groups:
- Potential acquirers value each segment in preparations for restructuring the company
- Investor’s interest in the sum of parts as “cheap” will lead to more interest in the company.
Using the sum of the parts valuation on holding companies or conglomerates like Berkshire Hathaway, GE, or United Technologies is a great way to value those companies.
The sum of the parts valuation, which is also known as the breakup analysis, helps investors understand the true value of the company.
We often hear that the company is worth more than the sum of its parts. A phrase like that tells us that the company’s segments might be worth more if sold off separately, as opposed to valuing the whole company.
Ok, let’s look at how we use the sum of the parts valuation to find the value of the company.
How do You Value a Business Segment?
The most common use of the sum of parts valuation is to value a company that is made up of different business units across multiple industries. Using this type of valuation makes sense in those situations because multiples or valuations differ across industries.
For example, you don’t value financials the same way you would value Amazon, and to mix the financials of an insurance company with a retail company can lead to “wrong” valuations.
Think of Berkshire, which contains many different businesses under the same umbrella.
There are three main types of valuations you can use in the sum of the parts valuations:
- Relative Valuations
- Comparable Acquisitions Analysis
- Discounted Cash Flows
The two most common types of valuations used for this method are relative valuations and discounted cash flows.
The most accurate if you have access to all the data necessary is the discounted cash flow, but unfortunately, not every company reports all the information necessary to calculate a DCF. The data we need to calculate a DCF, such as depreciation, is not always broken out by segment or business division, which makes using the DCF much more difficult.
Another issue with trying to utilize a DCF is if there is a financial unit tucked inside the company. Using a DCF is difficult because calculating cash flows for a bank is much more problematic and best to avoid.
The easiest method of valuation using the sum of the parts is relative valuation. In this type of valuation, we use multiples to express the value, and we compare them across similar companies in the same industry.
When using relative valuation, we can utilize metrics such as PE ratio, EV/EBITDA, Price to Book ratio, and PEG ratio. The sky is the limit on metrics, make sure you use ones that you can easily quantify, and you are sure of the definitions and that they are consistent.
The strength of this approach is that we can use different metrics across the band of the different business units within the company.
For example, if the business has under its umbrella segments such as automobiles, oil and gas, software, and a bank. We can use metrics such as PE ratio, EV/EBITDA, Price to Book ratio, and EV/Sales, respectively.
To value each unit of the business, there are multiple steps we must follow to set up the valuation.
The steps are as follows:
- Key characteristics of the segment – determine what type of industry it falls into and what are the main characteristics of the business. For example, Apple is most certainly in the software business, where Chevron is in the oil business. Also, determine if the business is an asset-heavy or asset-light entity. We are again looking at Apple, which is asset-light, and Chevron, which is asset-heavy.
- Choose an appropriate peer group – Make sure you pick an appropriate peer group to compare your multiples with and go with those as your comparisons. Again using Apple, it is better to choose Samsung as a competitor than Microsoft because they don’t easily operate in the same space or compete for the same customers.
- Select the correct multiple based on the sector – take care of choosing the right multiple for the sector you are working with; for example, choosing an EV/EBITDA for a banking sector will lead to only frustration. Choosing a multiple such as a PE ratio or Price to Book ratio would work much better. The nice thing about using the multiples is the ability to swap them out for comparison’s sake easily.
- Find the right multiple – There are several ways to go about finding the right multiple to use for each segment of your valuation. The first is to use a median of your peer group; the other is to use industry standards. To use the median, it is best to find the closest competitors and locate the multiples you want to use and then find the median of those numbers. The second choice is to use websites that calculate information by sector to use as your relative valuation multiple. Either way, you decide to go, be consistent with each segment.
To set up the valuation of a company that has many different businesses under its umbrella, we must first find the information on the financial reports, either using the latest quarterly statement and multiplying it by four to find a rough value of the segment data.
Or we can use the annual financials to calculate our sum of the parts valuation. Finally, you can find the TTM or trailing-twelve-month numbers to calculate the valuation. Again whichever method you choose, please be consistent.
Once we have the value of each of the segments, we add up the parts, and that gives us the enterprise value of the equity, then we add the cash and cash equivalents, then we subtract the debt. After all that, we divide by the shares outstanding of the company, and we arrive at our per-share value.
Ok, now that we understand the sum of the parts valuation and the process involved, let’s calculate a few to give us a sense of how this works.
Examples of Sum of The Parts Valuations
The first company I would like to value using the sum of the parts valuation is 3M (MMM), the conglomerate dividend aristocrat with a current market price of $157.27, and a market cap of $90.33 billion.
The first step is I will look up 3M in sec.gov and find the annual or 10-k report. Once I do that, I will read through the report to find the segment data. We are lucky because 3M lists all of their segment data separately under the Management Discussion and Analysis (MD&A) sections, and they list out both their sales and operating income or EBIT, which is the data we are looking to use.
3M breaks their company into four segments:
- Safety and Industrial ( 36.1% of sales)
- Transportation and Electronics (29.9% of sales)
- Health Care (23.1% of sales)
- Consumer (15.8% of sales)
Now that we see the breakout of the different segments of 3M let’s find the operating incomes for each segment per the annual report.
- Safety and Industrial – $2,648 billion
- Transportation and Electronics – $2,221 billion
- Health Care – $1,863 billion
- Consumer – $1,105 billion
- Corporate and Other – ($1,663)
The next step is to determine which industry each segment lines up with so we can determine what to use for our multiples.
- Safety and Industrial per the annual reports include adhesives and tapes, abrasives, electrical markets, and masking systems.
- Transportation and Electronics include electronics for display systems, automotive, and aerospace.
- Health Care segment includes items such as oral care, purification, drug delivery systems, and food safety.
- The consumer segment includes home improvement, stationery, and office supplies.
Now that we know the segments and what kind of products they deliver, we can determine what kind of industry they are closest too and find comparable metrics.
We can use either PE ratio or the EV/EBITDA multiple for any segment of this company, for giggles why don’t we use both and see what the difference is if there is one for the value of the company?
Ok, I will put a simple graph together to outline the possible multiples for each segment.
PE Ratio EV/EBITDA
Safety and Industrial 11.73 8.77
Transportation 25.00 13.07
Healthcare 32.00 11.74
Consumer 18.58 12.21
Now that we have that determined, we can take the operating income from each segment and multiply them by the multiples from above to find our enterprise value.
PE Ratio Sum of the Parts Valuation
- Safety and Industrial = $2,648 x 11.73 = $30,981.6
- Transportation = $2,221 x 25 = $55,525
- Healthcare = $1,863 x 32 = $59,616
- Consumer = $1,105 x 18.58 = $20,530.9
- Corporate and Other = ($1,663) x 18 = ($29,934)
Now, let’s do the same for the EV/EBITDA multiples.
- Safety and Industrial – $2,648 x 8.77 = $23,222.96
- Transportation – $2,221 x 13.07 = $29,028.47
- Healthcare – $1,863 x 11.74 = $21,871.62
- Consumer – $1,105 x 12.21 = $13,492.05
- Corporate and Other – ($1,663) x 13.75 = (22,866.25)
Let’s add up the totals to find our enterprise value.
PE Rate Value = 30981.6 + 55525 + 59616 + 20530.9 – 29934
PE Ratio Value = $136719.5
EV/EBITDA Value = 23222.96 + 29028.47 + 21871.62 + 13492.05 – 22866.25
EV/EBITDA Value = $43,848.85
Now that we have our enterprise values, let’s look up the cash on hand, debt, and shares outstanding from the annual reports.
- Cash and cash equivalents – $2,451
- Debt – $21,278
- Shares Outstanding – 585.1
The next step is to take our enterprise values and add the cash, subtract the debt, and divide by the shares outstanding to arrive at our value per share.
PE Ratio EV/EBITDA
Enterprise Value 136719.5 43848.85
Cash 2451 2451
Debt 21278 21278
Total 117892.5 25021.35
Shares Outstanding 585.1 585.1
Per Share $201.49 $42.76
So the big question is, which do you think is more likely, the PE ratio analysis or the EV/EBITDA analysis? I think it is somewhere in between, likely closer to the EV/EBITDA multiple as the company is closer to being overvalued than undervalued.
Let’s try another one, shall we?
How about AT&T?
The company breaks up AT&T by four segments and their reported EBITDA from the latest 10-k report:
- Communications – $50,559
- WarnerMedia – $9,702
- Latin America – $500
- Xandr – $1376
- Corporate and Other – ($5965)
Now, let’s assign multiples to each segment of AT&T; for ease of use, I am going to use EV/EBITDA multiples as that is how AT&T breaks out the segment revenue and earnings.
- Communicatons – $50,559 x 6.64
- WarnerMedia – $9702 x 10.12
- Latin America – $500 x 6.64
- Xandr – $1376 x 9.20
- Corporate and Other – ($5965) x 7.8
Let’s compute the segment values before finding our value for the company.
- Communications – $335711.76
- Warner Media – 98184.24
- Latin America – $3,320
- Xandr – $12,659.2
- Corporate and Other – $(46,527)
Adding up the segments gives us the total EBITDA for the company of $403,348.2
Now we can find the cash, debt, and shares outstanding to calculate our total value for the company.
- Cash and cash equivalents – $12,130
- Debt – $184,951
- Shares Outstanding – 7348
Ok, now we will add and subtract the cash and debt from the enterprise value of AT&T and find our value per share.
Per Share = ( 403348.2 + 12130 – 184951 ) / 7348
Per Share = 230527.2 / 7348
Per Share = $31.37
The current market price of AT&T is $30.34, which puts within range of our multiples based on the market multiples for communications companies that AT&T is similar too, such as Verizon and T-Mobile.
That was easy, wasn’t it?
The hardest part is finding the correct industry multiples to assign to your segments; once that is done, then the math is straightforward.
A great tool to help you find the sector multiples is the following website:
The above valuation method is fairly straightforward to use, but as you will see below, there are a few cons to this style of valuation.
Sum of Parts Valuation Pros and Cons
Using the sum of the parts valuation is a simple, straightforward method of valuing companies. It lets you dissect each segment of the business and helps you determine what the more important segments of the business are.
For example, with the shutdown of theme parks and movie theaters Disney could conceivably be on the ropes, but by utilizing a sum of the parts valuation, you can see that Disney derives some of its value from other parts of its business and if it can hang on until the health situation starts to improve then Disney can climb out of any hole.
Some drawbacks to this type of valuation are:
- Not useful for companies with a single line of business
- Not every company discloses information on each segment of its business, or the information is unavailable in other sources.
- The more inputs, the more opportunity for mistakes.
Let’s explore that last point for a moment. When doing any type of valuation, we are using estimates or historical data. Any time we use either one of those data points, there are interpretation error possibilities. And the more inputs, the more likelihood of we the investor making a mistake which could lead to mistakes in investment choices. Sometimes the simplest model is the best model, not using complicated for complicated sake.
The last issue with using a sum of the parts valuation is that it is a pricing game, not necessarily a valuation. When we use multiples to arrive at a valuation, we are entering into the arena where the price is the more important variable as opposed to the cash flows of the business. Pricing is dependant on market forces, where cash flows are dependant on the operations of the business and decisions of management.
The sum of the parts valuation is an effective tool to find the value of different segments of any business you are looking to value. It is a simple, straightforward way to value any business that has more than one line of business.
The most important consideration to keep in mind when using this valuation method is to be internally consistent with your multiples and with your decisions on how you segment the different areas of the business.
The sum of the parts valuation is a big weapon used by sell-side analysts when they are determining the value or price of a company. They look at others in the same industry for each segment of the business and price it accordingly. The analysts see it as a way of extracting value out of each segment as if it was a standalone business.
I encourage you to experiment with this type of valuation to give you a better idea of the overall value of the business as well as the value of each part of the business. It is also a fantastic way to become better familiar with each segment of the business. It is also a fantastic way to compare the more traditional methods, such as a DCF, to see if those calculations are in the ballpark.
Remember, the price we pay is important, and learning to value a business is an important skill to learn, practice, and, hopefully, one day master.
That is going to wrap up our discussion for today.
As always, thank you for taking the time to read this post today. I hope you find something of value on your investing journey.
If I can be of any further assistance, please don’t hesitate to reach out.
Until next time, take care and be safe out there,