What is SOTP?
Sum-of-the-Parts Analysis (SOTP) estimates the value of each business segment within a company separately, which are then added together to arrive at the company’s implied total enterprise value.
How to Perform Sum of the Parts Valuation (“Break-Up” Analysis)
The sum-of-the-parts valuation (SOTP) is most appropriate for valuing companies with divisions that are each distinct from one another from a risk/return standpoint, which creates 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 – i.e., 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 business segments.
SOTP Valuation Methodology (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 Calculated Valuations for Total Firm Value
- Step 4 → Subtract Net Debt and Non-Operating Items
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 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.
Real-Life Application of Sum-of-the Parts Analysis
Although the most common reason to use SOTP analysis is for companies with business segments in different industries, another scenario when SOTP can be useful is restructuring.
Oftentimes, one of the first steps taken by a distressed company in immediate need of restructuring is to identify underperforming, non-core business segments – which could then be sold if a suitable buyer is found (i.e. distressed M&A).
Another frequent use-case of SOTP is for spin-offs and related activities. 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.
Biotech SOTP Valuation Example
One industry in which SOTP is relied upon is biotech, particularly for clinical-stage, pre-revenue companies. Here, a greater range of assumptions is required for each therapeutic asset, such as the market size, revenue potential, as well as the “probability of success (POS)” to address the uncertainty surrounding the FDA 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 – contingencies that a properly built model must account for.
Biotech Sum-of-the-Parts Valuation (Source: Industry-Specific Modeling)
Limitations of Sum of the Parts Valuation (SOTP)
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.
Companies, including conglomerates, rarely provide sufficient information in their filings to build a complete model and value for each segment.
The difficulty in compiling the required information can force broader assumptions to be used instead, which can cause these valuations to be less credible.
Furthermore, 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.
Berkshire Hathaway Conglomerate: Operating Business Segments
SOTP valuations are often used when the target has several operating divisions in unrelated industries, each with different risk profiles (i.e. a conglomerate like Berkshire Hathaway).
Conglomerate Business Segments Example (Source: Berkshire 2020 Annual Report)
SOTP Valuation Model – Excel Template
We’ll now move to a modeling exercise, which you can access by filling out the form below.
Step 1. Operating Assumptions
Our SOTP modeling tutorial will start with some background details regarding the hypothetical company.
The company consists of three segments that 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
Implied Equity Value = Total Enterprise Value (TEV) – Net Debt
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