Definition
The Sum-of-the-Parts Valuation (SOTP) is a financial analysis method where a company’s total value is determined by adding up the separate values of each of its business units or divisions. This approach is often used for conglomerates to determine what the company would be worth if its segments were to be sold off separately. It allows analysts to identify potentially undervalued or overvalued segments within a larger company.
Phonetic
The phonetic pronunciation of “Sum-of-the-Parts Valuation (SOTP)” would be /sʌm-ɒv-ðə-pɑːrts væl.juːˈeɪ.ʃən (sɒtp)/.
Key Takeaways
- Assesses Separate Components: Sum-of-the-Parts Valuation (SOTP) is a method of valuation by which a company’s total worth is evaluated as an aggregate of its separate operating sectors or components. This can be useful in identifying business areas that may be undervalued or overvalued by the market.
- Used for Multi-Business Entities: SOTP valuation is especially relevant for multi-business or diversified corporations. It offers a structure for assessing the contribution of each business sector to the consolidated total, so stakeholders can have a better understanding of business segment performance and value.
- Useful for Acquisition, Disposition and Other Strategic Decisions: This method can provide important insights whether to buy a business (acquisition), sell parts of the business (disposition), or make other strategic decisions such as mergers and de-mergers. The valuation allows the main entity to understand which parts are contributing more value and should possibly be kept and which ones are underperforming or do not align with the entity’s core strategy and might be sold.
Importance
The Sum-of-the-Parts Valuation (SOTP) is a significant business/finance term as it provides an approach to assessing the total value of a company by evaluating its separate business units or holdings independently. This tactic is typically useful when the company’s composite segments are thought to be worth more individually than when amalgamated. The SOTP valuation offers valuable insight into conglomerates where there might be numerous diversified businesses under the parent company. It allows the investor or firm to understand if the collective components, when valued separately, present a different picture compared to the full enterprise value, hence creating a more detailed, informed investment viewpoint. This could designate the potential for increased shareholder value if the company were to decide on divesting, spinning off, or selling certain parts.
Explanation
The Sum-of-the-Parts Valuation (SOTP) is a valuation method that financial analysts and investors often use to determine the value of a diversified company or conglomerate. The primary objective of a SOTP valuation is to evaluate what a company could be worth if its business units or underlying assets were separately valued and added together. This approach can help analysts understand the overall worth of a business by breaking it down to its constituent components, revealing any potential undervaluation or overvaluation that a more holistic analysis might miss. The SOTP valuation method is particularly useful when auditing an organization that operates in various sectors or has several diversified business units. For example, consider a multinational corporation with operations in real estate, energy, and retail. If a standard unified valuation approach doesn’t adequately account for variances in the industries’ value drivers, an analyst might use SOTP to derive a more accurate valuation. A SOTP valuation can reveal hidden value by assigning specific valuations to different divisions based on relevant multiples or comparable companies in respective sectors. This method also helps in the context of mergers and acquisitions by providing a breakup value should a firm disassemble and sell its parts independently.
Examples
1. Disney’s Sum-of-the-Parts Valuation: Disney has a vast number of diverse business segments: filmmaking, broadcasting, merchandising, theme parks, and more. Each of these elements can be assessed independently for valuation. For instance, the value of its theme parks could be determined by comparing it with other similar standalone amusement parks. Similarly, the value of its film division could be based on comparisons with other movie studios. By adding up all these valuations, an overall estimate of Disney’s business value can be achieved using the SOTP method.2. Amazon’s SOTP Valuation: Amazon is another company with diverse business segments, including their massive eCommerce platform, Amazon Prime video, Amazon Web Services (AWS), and many more smaller segments. In an SOTP valuation, each of these segments would be valued independently. For example, AWS could be valued in comparison with other cloud services, while the eCommerce platform could be valued based on the similar e-retail businesses. All these valuations are then summed up to get the total business value.3. Conglomerate Companies like Berkshire Hathaway: Warren Buffet’s company Berkshire Hathaway is a conglomerate with investments in many different industries, such as insurance, rail transportation, utilities and energy, manufacturing, services, and retailing. When analysts perform an SOTP valuation on a company like this, they’re going to evaluate each business segment separately, often comparing them with similar standalone companies in each respective industry. Once each ‘part’ is valued, they then sum these values to reach a total valuation for the entire conglomerate.
Frequently Asked Questions(FAQ)
What is Sum-of-the-Parts Valuation (SOTP)?
Sum-of-the-Parts Valuation (SOTP) is a financial modelling technique, often used in financial analysis and business valuation, where you break down a company’s operating segments or subsidiaries and value each one individually. Those different parts are then added back together to calculate the total value of the company.
When should SOTP valuation be used?
This type of valuation model is particularly useful for diversified or conglomerate companies that operate in different industries or areas of business. If these separate business units are materially different from each other, valuing them as one can lead to incorrect conclusions.
How is a Sum-of-the-Parts Valuation carried out?
SOTP comprises three main steps: identifying the parts, valuing the parts, and summing the valued parts. The valuation of individual parts could be performed using any acceptable valuation method like DCF (Discounted CashFlow), P/E (Price to Earnings) multiple valuation, etc., depending on the nature of each part.
What are the advantages of SOTP valuation?
The sum of the parts valuation can lead to more accurate analysis because it looks at each segment of the business separately. Moreover, it helps identify less profitable or underperforming segments within the company.
What are the limitations of SOTP valuation?
If not correctly identified and valued, some subsidiaries may be overlooked in SOTP valuation, leaving out important assets. Additionally, there are often synergies between different business units that can be difficult to evaluate but that add to the overall company’s value.
Is SOTP valuation applicable to all types of companies?
Not necessarily. SOTP is most suitable for multi-segmented companies or conglomerates with distinct business units. For single-segment or smaller companies, other methods such as DCF or P/E valuation may be more suitable.
Can SOTP valuation be used to identify investment opportunities?
Yes, SOTP can be a powerful tool for investors. If the SOTP valuation is significantly higher than the current market cap, it might imply that the company’s stock is undervalued, thus presenting a potential investment opportunity.
Is SOTP valuation the same as breakup value?
Not exactly. While both methods involve assessing the value of individual segments, breakup value refers to the net value if all the company’s assets were individually sold off. SOTP, on the other hand, values the business units as ongoing concerns, including the potential future profitability and growth.
Related Finance Terms
- Equity Valuation
- Asset-based Valuation
- Market Capitalization
- Business Unit
- Private Equity
Sources for More Information
