Understanding the Essence of Sum-of-the-Parts Valuation (SOTP)
The sum-of-the-parts valuation (SOTP) method involves valuing a company by determining what its aggregate segments would be worth if they were spun off or acquired by another entity. This valuation technique provides an accurate estimate of a company’s overall equity value by calculating the standalone value of each of its business divisions, ultimately arriving at a single total enterprise value (TEV).
The SOTP Valuation Formula
The SOTP formula can be expressed as below:
[ \text{SOTP} = N_1 + N_2 + \ldots + N_D - N_L + N_A ]
where:
- N1 = Value of the first segment
- N2 = Value of the second segment
- ND = Net debt
- NL = Non-operating liabilities
- NA = Non-operating assets
Key Aspects of Sum-of-the-Parts Valuation
- Holistic Insight: SOTP calculates the worth of individual divisions as if they were sold separately.
- Strategic Analysis: Provides a critical measure for hostile takeovers or corporate restructuring.
- Conglomerate Focus: Particularly useful for conglomerates with business units across different industries.
Steps to Calculate SOTP Valuation
To calculate the SOTP valuation, the value of each business unit is derived separately using methods like:
- Discounted Cash Flow (DCF) Analysis
- Asset-Based Valuation
- Revenue, Operating Profit, or Profit Margin Multiples
Insights from SOTP Valuation
Often referred to as breakup value analysis, SOTP helps in understanding a company’s true worth. If a young technology firm is described as “worth more than the sum of its parts,” it implies that its divisions would garner more value if sold separately.
Larger enterprises can leverage synergies and economies of scale that smaller firms cannot, thereby maximizing profitability and unlocking new value for each segment.
SOTP is apt for valuing companies with distinct business units across various industries, safeguarding against hostile takeovers and evaluating firms post-restructuring.
Real-World Application of SOTP Valuation
Imagine United Technologies (NYSE: UTX), which announced in late 2018 that it will break into three units—an aerospace company, an elevator firm, and a building systems enterprise. Using the 10-year median enterprise value-to-EBIT multiple for peers and 2019 operating profit estimates:
- Aerospace Business: Valued at $107 billion
- Elevator Business: Valued at $36 billion
- Building Systems Business: Valued at $52 billion
Putting it all together, the total value amounts to $194 billion. After deducting net debt and other liabilities of $39 billion, the final SOTP valuation stands at $155 billion.
Comparing SOTP with Discounted Cash Flow (DCF)
While SOTP and DCF are both valuation tools, the SOTP often utilizes a DCF analysis for valuing segments. The DCF technique, on the other hand, values a business, a project, or a segment by using discounted future cash flows.
Limitations of SOTP Valuation
The key challenges of the SOTP approach include dealing with a multitude of valuations and inputs, along with not accounting for tax implications, especially those involved in spinoffs.
Enhance Your Valuation Skills
Continue enhancing your valuation skills by choosing the right tools tailored to your specific business needs. Be a step ahead in understanding and leveraging SOTP valuations for maximal strategic advantage.
Related Terms: Total Enterprise Value, Non-Operating Assets, Profit Margins, Discounted Cash Flow, Breakup Value
