# Sum of the Parts Valuation – When a Company Has Many Business Segments

Valuation is part art, part math, and valuing a company encompasses many moving parts. Suppose we want to value a company and notice several different businesses tied up in the company. How do you value such a company? One of the best ways to value those 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, and it can also help you determine what segment drives the most value for the business.

A company such as Berkshire Hathaway contains a sum of parts of many businesses that consist of the operations of Berkshire. The company represents 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, the best method remains using a sum of the parts valuation.

As you will see through this post, valuation 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 the following:

## What is a Sum of the 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 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:

1. 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.
2. Accounting mission – As the US and other countries have adopted accounting standards that turn to “fair value” accounting, accountants have been tasked with redoing balance sheets to show the “fair value” instead of book value.
3. 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:
1. Potential acquirers value each segment in preparations for restructuring the company
2. Investor’s interest in the sum of the 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, also known as the breakup analysis, helps investors understand the company’s true value.

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 separately instead of valuing the whole company.

Let’s look at how we use the sum of the parts valuation to find the company’s value.

## How do You Value a Business Segment?

The most common use of the sum of the parts valuation is to value a company made up of different business units across multiple industries. This type of valuation makes sense because multiples or valuations differ across industries.

For example, you don’t value financials the same way you would value Amazon, and mixing 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

This method’s two most common valuations are relative valuations and discounted cash flows.

The discounted cash flow remains the most accurate if you have access to all the data necessary. Still, unfortunately, not every company reports all the information necessary to calculate a DCF. The data we need to calculate a DCF, such as depreciation, doesn’t always get broken out by segment or business division, which makes using the DCF much more difficult.

Another issue with utilizing a DCF is if a financial unit hides inside the company. Using a DCF remains difficult because calculating cash flows for a bank can prove challenging.

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 compare them across similar companies in the same industry.

We can use relative valuation metrics such as P/E 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, remain sure of the definitions, and stay 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 the P/E ratio, EV/EBITDA, Price to Book ratio, and EV/Sales, respectively.

To value each unit of the business, we must follow multiple steps to set up the valuation.

The steps are as follows:

1. Key characteristics of the segment – determine what type of industry it falls into and the business’s main characteristics. For example, Apple operates in the software business, whereas Chevron operates in the oil business. Also, determine if the business offers an asset-heavy or asset-light model. Apple is an asset-light business, whereas Chevron is an asset-heavy model.
2. Choose an appropriate peer group – Make sure you pick an appropriate peer group to compare your multiples 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.
3. Select the correct multiple based on the sector – choose the right one for the sector you are working with; for example, choosing an EV/EBITDA for a banking sector will only lead to frustration. Choosing a multiple such as a P/E 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.
4. Find the right multiple – There are several ways to find the right one for each valuation segment. 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, 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 as your relative valuation multiple. Either way you decide to go, be consistent with each segment.

To set up the valuation of a company with many different businesses under its umbrella, we must first find the information on the financial reports, either using the latest quarterly statement or 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 (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, giving us the enterprise value of the equity; then, we add the Cash and cash equivalents, then 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.

## Example of Sum of the Parts Valuations

The 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 will look up 3M on sec.gov and find the annual report (10-K). Once I do that, I will read through the report to find the segment data. We are lucky because 3M lists all 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 its company into four segments:

• Safety and Industrial (36.4% of sales)
• Transportation and Electronics (27.3% of sales)
• Health Care (25.6% of sales)
• Consumer (16.5% 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 – \$12,880 million
• Transportation and Electronics – \$9,769 million
• Health Care – \$9,050 million
• Consumer – \$5,856 million

The next step is to determine which industry each segment lines up with so we can determine what to use for our multiples.

Per the annual reports, Safety and Industrial include adhesives and tapes, abrasives, electrical markets, and masking systems.

Transportation and Electronics include electronics for display systems, automotive, and aerospace.

The Health Care segment includes 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 industry they are closest to and find comparable metrics.

We can use either the P/E ratio or the EV/EBITDA multiple for any segment of this company; for giggles, why don’t we use both and see the difference if there is one for the company’s value?

Ok, I will put a simple table together to outline the possible multiples for each segment.

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.

P/E Ratio Sum of the Parts Valuation

Safety and Industrial = \$2,692 x 11.73 = \$31,577

Transportation = \$2,008 x 25 = \$50,200

Healthcare = \$2,150 x 32 = \$68,800

Consumer = \$1,248 x 18.58 = \$23,187

Now, let’s do the same for the EV/EBITDA multiples.

Safety and Industrial – \$2,692 x 8.77 = \$23,608

Transportation – \$2,008 x 13.07 = \$26,244

Healthcare – \$2,150 x 11.74 = \$25,241

Consumer – \$1,248 x 12.21 = \$15,238

Let’s add up the totals to find our enterprise value.

PE Rate Value = 31,577 + 50,200 + 68,800 + 23,187

PE Ratio Value = \$173,764

EV/EBITDA Value = 23,608 + 26,244 + 25,241 + 15,238

EV/EBITDA Value = \$90,331

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 – \$2,984
• Debt – \$17,196
• Shares Outstanding – 579

The next step is to take our enterprise values and add the Cash, subtract the debt, and divide by the outstanding shares to arrive at our value per share.

So the big question remains, which do you think is more likely, the P/E ratio analysis or the EV/EBITDA analysis? Most likely, the results will hover between the two results.

A great tool to help you find the sector multiples is the following website:

NYU Stern

The above valuation method is fairly straightforward, but as you will see below, there are a few cons to this valuation style.

## Sum of the 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 the more important segments of the business.

For example, Disney could be on the ropes with the shutdown of theme parks and movie theaters. Still, 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, 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 valuation, we use 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 likely we, the investor, make a mistake which could lead to mistakes in investment choices. Sometimes the simplest model is the best model, not using complicated models for complicated sake.

The last issue with using a sum of the parts valuation relates to a pricing game, not necessarily a valuation. When we use multiples to arrive at a valuation, we enter the arena where the price becomes a more important variable than the business’s cash flows. Pricing depends on market forces, whereas cash flows depend on the business’s operations and management decisions.

## Final Thoughts

The sum of the parts valuation offers us an effective tool to find the value of different segments of any business you want to value. It is a simple, straightforward way to value any business with more than one line of business.

Consistency remains the most important consideration to keep in mind when using this valuation method. We must remain internally consistent with our multiples and decisions on segmenting the different areas of the business.

The sum of the parts valuation remains a big weapon used by sell-side analysts when determining a company’s value or price. They look at others in the same industry for each business segment and price it accordingly. The analysts see it as a way of extracting value from each segment as 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 and the value of each part of the business. Sum of parts valuations offer a fantastic way to become more familiar with each business segment. We can also use them 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, master one day.

That is going to wrap up our discussion for today.

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,

Dave

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