Sum of the Parts (SOTP)

How to Perform Sum of the Parts Valuation (SOTP)

The sum-of-the-parts valuation (SOTP) is most appropriate for valuing companies with multiple divisions that are each distinct from one another from a risk/return standpoint, creating the need to “break up” the company into separate components for the valuation to be more accurate.

For companies suitable for a SOTP valuation, under the discounted cash flow approach (DCF), each of their segments would adhere to a different discount rate, which means the expected returns (and coinciding risks) of each individual segment would differ.

If attempting to value the company through multiples analysis – either via comparable company analysis or precedent transactions – it’ll be quite challenging to determine a single appropriate trading or transaction multiple, considering just how widespread the implied ranges will be across the different business segments.

Structure of SOTP Valuation Method (Step-by-Step)

The SOTP valuation methodology can be broken into four steps:

• Step 1 →  Identify the Appropriate Business Segments
• Step 2 →  Perform Standalone Valuations of Each Segment (Comps, DCF)
• Step 3 →  Add-Up the Calculated Valuations for the Total Enterprise Value (TEV), i.e. Total Firm Value
• Step 4 →  Subtract Net Debt and Non-Operating Items from TEV

From the total enterprise value (TEV), or “total firm value”, the company’s total net debt (gross debt less cash and equivalents) yields the implied equity value, i.e. the residual value attributable to only common shareholders.

By dividing the implied equity value by the total number of shares outstanding, we arrive at the SOTP-derived share price, which can then be compared to the current pricing in the open markets to determine if the shares are undervalued, overvalued, or fairly valued.

SOTP Formula

As implied by the name, SOTP entails valuing each underlying piece of a company separately and then adding them together, rather than valuing the entire company in aggregate using traditional means.

The objective of SOTP is to value each part of the company separately and then add all the calculated values together. Then, upon deducting net debt from the enterprise value, the implied equity value can be derived.

Once the sum of each segment’s firm values (TEV) has been determined, the remaining step is to subtract net debt and any non-operating assets or liabilities unrelated to shareholders in order to calculate equity value, as mentioned in the prior section.

When to Use SOTP Analysis?

• Conglomerates: The most common reason to use SOTP analysis is to perform valuation analyses on companies with multiple business segments operating in different industries – such as conglomerates – where the risk/return profile varies by the specific segment.
• Restructuring: The SOTP can also be useful is restructuring, which refer to scenarios in which the company, or the “debtor”, is at risk of financial distress and becoming insolvent. Oftentimes, one of the first steps taken by a distressed company in urgent need of restructuring is to identify underperforming, non-core business segments. Those particular segments could be sold to increase the company’s liquidity, assuming a suitable buyer is found (i.e. distressed M&A) – albeit, a steep discount in the sale price is standard in such scenarios.
• Spin-Offs: Another frequent use-case of SOTP is for divestitures, such as spin-offs. From the SOTP in the stated context, the question attempting to be answered is: “Is the whole greater than the sum of its parts?” If yes, the subsidiary would be better off remaining part of the parent company. However, if the answer is no, then the subsidiary could actually be in a more favorable position if spun off.

SOTP Valuation Example: Biotech Sector

One sector in which SOTP analysis is relied upon is the biotech sector, particularly for clinical-stage, pre-revenue companies.

Performing a valuation on a biotech company requires a wide range of assumptions per therapeutic asset – such as the estimated market size, revenue potential (“peak opportunity”) and uptake curve post-product launch – as well as the probability of success (POS) rate.

The product-level assumptions are intended to address the uncertainties surrounding a product’s path to commercialization, namely the clinical FDA trials as part of the regulatory approval process.

Earlier-stage therapeutic assets, compared to those in the later stages of obtaining regulatory approval (or even commercialization), have a far lower probability of success and are therefore inherently riskier. Hence, a robust biotech SOTP model must account for such contingencies.

^{Biotech Sum-of-the-Parts Dashboard (Source: Biotech SOTP Valuation Course)}

What are the Limitations of SOTP Valuation Analysis?

• Limited Segment-Level Data → Even if the basis of SOTP valuations seems fundamentally sound (or even preferable to standalone valuations), the limited amount of publicly available segment-level data can be a major drawback. Public companies, including conglomerates, rarely provide sufficient information in their filings to build a complete model and value for each segment
• Reliance on Broad Assumptions → The difficulty in compiling the required information can force broader assumptions to be used instead, which can cause the valuation range output by the SOTP model to be less credible.
• Treatment of Synergies →  Similar to how synergies are realized post-M&A, the synergies that result across divisions such as the cost savings benefiting each segment cannot be isolated nor easily distributed across business segments.

SOTP Conglomerate Example: Berkshire Hathaway

SOTP valuations are often used when the target has several operating divisions in unrelated industries, each with different risk profiles. For instance, a conglomerate like Berkshire Hathaway, which states the following business divisions in its annual report.

^{Conglomerate Business Segments Example (Source: Berkshire 2020 Annual Report)}

SOTP Valuation Model

We’ll now move to a modeling exercise, which you can access by filling out the form below.

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Step 1. Segment-Level Financial Assumptions

Our SOTP modeling tutorial will start with some background details regarding the hypothetical company.

The company consists of three segments – Segment A, B, and C – which are each valued at different multiples and operate in different industries.

Here, the comps-derived valuation is estimated using the “Low” and “High” end of the EV/EBITDA multiple ranges pulled from each segment’s peer group.

Segment A: Financial Assumptions

• EBITDA = $100 million
• Low, EV/EBITDA = 6.0x
• High, EV/EBITDA = 8.0x

Segment B: Financial Assumptions

• EBITDA = $20 million
• Low, EV/EBITDA = 14.0x
• High, EV/EBITDA = 20.0x

Segment C: Financial Assumptions

• EBITDA = $10 million
• Low, EV/EBITDA = 18.0x
• High, EV/EBITDA = 24.0x

Clearly, Segment A contributes the most EBITDA to the company, but the total firm valuation multiple appears to be weighed down by its comparatively lower EV/EBITDA multiple.

Step 2. Enterprise Value Calculation per Business Segment

The next step is to calculate the enterprise value of each segment – both at the lower and upper end of the valuation range.

By multiplying the EV/EBITDA multiple by the corresponding EBITDA metric for each segment, we can determine the segment enterprise values.

Upon completing each division’s valuation, the values are added up to arrive at the total enterprise value (TEV).

• Total Enterprise Value (TEV), Low = $600 million + $280 million + $180 million = $1.06 billion
• Total Enterprise Value (TEV), High = $800 million + $400 million + $240 million = $1.44 billion

Step 3. Implied Equity Value from SOTP Analysis

Once the firm values have all been calculated, the final step in our modeling exercise is to subtract net debt, which we assume to be $200m.

• Net Debt = $200 million

On the lower end of the valuation range, the implied equity value of our company is $860m, whereas, on the higher end of the range, the implied equity value is $1.24bn.

• Equity Value, Low = $1.06 billion – $200 million = $860 million
• Equity Value, High = $1.44 billion – $200 million = $1.24 billion