Sum-of-the-Parts Valuation (SOTP) 

The world of investments and corporate finance is deeply rooted in how well a business can be valued. For conglomerates or companies operating in different sectors, standard valuation methods might not capture all the unique contributions of individual business units. That is where SOTP comes in as one of the powerful analytical tools that helps determine the overall value of the business enterprise. 

SOTP valuation breaks down a company into its individual segments, valuing each separately and then summing these values to arrive at an overall enterprise value. This article is a detailed exploration of the intricacies of SOTP valuation, including methodology, applications, limitations, and real-world examples. 

What is Sum-of-the-Parts Valuation (SOTP)? 

Sum-of-the-parts valuation, or SOTP, is a valuation approach that aggregates the value of business units to provide an estimate of the total business value. It is helpful for: Conglomerate Companies have different business units dealing in various sectors and geographies. Diversified Businesses: Businesses with a variety of products or services, dealing in various sectors, where each business may have different growth paths and risk profiles. Restructuring Cases Where a business may consider selling off, merging, or spinning off one or more business units. 

The central idea of SOTP is simple: the total worth of a business is simply the sum of its parts. Each component is valued separately, using the best available valuation method for the specifics of that component. When these components are aggregated, the result tends to be clearer and even more accurate as a reflection of the company’s overall worth. 

Understanding Sum-of-the-Parts Valuation (SOTP) 

Principles of SOTP 

1. Segmentation: The first step in SOTP is to divide the business into its operational units. Each unit is treated as a separate entity for valuation, based on its unique functions, market, or product lines.
2. Single Segment Valuation: Each of the segments is valued individually keeping in mind the market position and growth prospects, as well as financial performances. Different valuation techniques, either DCF analysis or comparable company analysis, may be suitable for different segments.
3. Adjustments: Once the values of all segments are calculated, then adjustments are made to account for corporate-level factors. These include liabilities, such as debt, and non-operating assets, such as surplus cash or real estate.
4. Result: Once adjusted, the sum of the segment values gives the total value of the company’s equity, which can be summarised in a very detailed way.

Why Apply SOTP? 

1. Uncover Hidden Value: SOTP identifies the inherent value of individual business units that might otherwise be masked when viewed at a company level. This is particularly useful in uncovering under-valued segments.
2. Strategic Decision Making: Knowledge of value at each line of business, SOTP supports strategic initiatives like a divestiture, acquisitions or spindles. It helps organisations to identify and focus only on high-value areas while exiting low-performing units.
3. Market Perception: SOTP can establish the difference between the actual worth of a company that exists in the market’s valuations, which will finally help investors make better decisions

Valuation of Individual Segments 

The valuation of individual segments is the crux of SOTP. This requires proper analysis and a choice of appropriate valuation methods 

Process of Segment Valuation  

1. Identification of business segments

First of all, disintegrate the company to its operational units. It is often based on the following factors; 

Industry: For example, General Electric, a conglomerate. Segments may exist such as aerospace, healthcare and energy. 

Geography: A firm could organise its business activities into separate regions. 

Product Lines: A company like Procter & Gamble might divide its segments into personal care, home care, and healthcare. 

2. Selecting Valuation Methods

Each segment is valued through methods appropriate to its nature. The most common methods include: 

Discounted Cash Flow (DCF) Analysis: 

Projects cash flows for the segment into the future. 

Discounts those cash flows to their present value using a suitable discount rate. 

Comparable Company Analysis (Comps): 

Identifies companies that are publicly traded in the same industry. 

Obtains multiples of valuation (such as EV/EBITDA, P/E) in order to determine the value of the segment. 

Precedent Transactions: 

Relies on the multiples derived from similar transactions in the same sector. 

3. Value Calculation of Segments

When the selected valuation method is applied, every segment’s value is determined. Generally, assumptions over growth rates, margins, and capital expenditure needs are incorporated. 

4. Insert the Values

Add up the values of all the segments to come up with the company’s total enterprise value, TEV. 

5. Control for Corporate Level Effects

Lastly, adjustments are made for the following: 

Net Debt: Net debt = Total debt minus Cash. 

Non-Operating Assets/Liabilities: Add or deduct any item that is not considered to be part of core activities, such as excess property and pension obligations. 

SOTP Formula 

SOTP valuation can be summed mathematically as follows: 

Where, 

Value of every division is obtained by separate valuation. 

Net Debt = Debt amount minus Cash and Cash equivalents. 

Non-operating assets may include surplus cash or non-core real estate. 

Limitations of SOTP Valuation 

Though Sum-of-the-Parts Valuation (SOTP) offers great insights, it has several limitations too: 

1. Complexity:

SOTP requires deep financial data and analysis for every segment, which is time-consuming and resource-intensive. The process also requires different valuation techniques for different segments, which makes it very complex and resource-intensive. 

2. Subjectivity

This is the valuation process entirely relying on future growth rate assumptions, discount rate assumptions, and other market conditions assumptions. These analysts might or might not consider them properly. Differences are very thin sometimes. Divergence results in some cases where both calculate a valuation for the same segment, but the total outcome will be wrong. 

3. Market Forces

The values of the SOTP may not reflect the market perceptions, especially when the markets are volatile or uncertain. External factors like the economic cycle or market sentiment distort the valuations disproportionately and render this misleading in reflecting the true value of the segment. 

4. Management of Non-Core Assets

The valuation of the non-core or the laggard segments is quite difficult, as their future contribution can never be ascertained. The true value of such assets also becomes difficult to determine, particularly if they are not a part of the core business operations. 

5. Synergies and Overlaps

SOTP fails to capture synergies or interdependencies between the segments. Overlapping factors can create value that does not get reflected in individual valuations of the segment. 

Though SOTP offers a panoramic view of the value of a firm, it is a cumbersome and subjective valuation methodology for market influence and synergies. 

Examples of SOTP Valuation 

Example 1: United Technologies Corporation (UTC) 

One of the largest diversified industrial conglomerates, United Technologies or UTC, underwent significant restructuring in 2018. It had decided to split into three distinct and standalone businesses: aerospace, building systems, and HVAC systems. Analysts used the SOTP method to estimate the values of the separated entities. 

Segment Valuation 

1. Aerospace: US$107 billion – using peer comparison analysis of the industry
2. Building Systems (Otis Elevators): US$36 billion
3. HVAC (Carrier): US$52 billion.

Net Debt Total Valuation 

Subtract US$39 billion net debt from the above 

This valuation illustrated the value that would be unlocked if the segments were separated. 

Example 2: 3M Company 

3M is a multinational conglomerate that produces industrial, healthcare, and consumer products. Analysts commonly perform SOTP valuations to appreciate the relative contribution of the different segments. 

Segment Valuation 

1. Industrial Products

It has a valuation of US$25 billion, using industry multiples. 

2. Healthcare Products

It has an estimated valuation of US$20 billion. 

3. Consumer Products

It has a valuation of US$15 billion. 

Total Valuation 

Adjusting for $10 billion net debt: 

Equity Value= 60-10 =US$50 billion 

Frequently Asked Questions