Understanding Sum of the Parts Valuation (SOTP)

The Sum-of-the-Parts Valuation (SOTP) is a financial analysis technique used to evaluate a company by assessing the individual worth of its various divisions or business segments. This method is particularly beneficial for conglomerates or businesses with diversified operations, enabling analysts and investors to derive a comprehensive view of the company's overall value.

What is SOTP Valuation?

The SOTP valuation seeks to answer the question: What would each segment of a company be worth if it were to be sold off separately? To arrive at this figure, the valuation aggregates the standalone value of each business unit, ultimately resulting in a total enterprise value (TEV). The final equity value then accounts for the company's net debt and any non-operating assets or liabilities.

The SOTP Formula

The SOTP valuation can be expressed mathematically as:

[ \text{SOTP} = N_1 + N_2 + \ldots + N_D - N_L + N_A ]

Where: - (N_1), (N_2), ..., (N_D) = Values of each business segment - (N_L) = Non-operating liabilities - (N_A) = Non-operating assets - (N_D) = Net debt (gross debt less cash and equivalents)

This formula provides a clear breakdown of each component contributing to the overall valuation, allowing investors and stakeholders to understand how each segment is performing relative to the others.

Key Takeaways of SOTP

1. Individual Value Assessment: SOTP focuses on determining the value of individual divisions, which can reveal insight into the true worth of a company.
2. Relevant for Conglomerates: This valuation method is especially relevant for conglomerates that operate in various industries, thus facing distinct market dynamics and performance metrics.
3. Hostile Takeover Defense: In the event of a takeover attempt, SOTP can help demonstrate a company's value as a collection of profitable units, potentially dissuading unwanted acquisitions.

Calculating SOTP Valuation

To calculate the SOTP, valuation analysts may employ different techniques, each tailored to the unique characteristics of a business segment. Common valuation methods include:

• Discounted Cash Flow (DCF) Analysis: Projects future cash flows and discounts them to present value.
• Asset-based Valuations: Focuses on the inherent value of a company's tangible and intangible assets.
• Multiples Valuation: Utilizes industry-specific multiples (such as revenue or operating profit) to estimate value.

Insights Gained from SOTP

By implementing SOTP, companies gain a clearer understanding of their inherent value—often referred to as the "breakup value." For example, a press release may state that a firm is "worth more than the sum of its parts," suggesting that collective synergies may be underestimated. Larger companies often capitalize on operational efficiencies, maximizing profitability in ways smaller firms cannot.

Real-world Application: United Technologies Case Study

United Technologies (NYSE: UTX) provides a practical example of SOTP application. In late 2018, the company announced plans to segregate into three distinct units, focusing on aerospace, building systems, and elevators. By applying a 10-year median enterprise value-to-EBIT (EV/EBIT) multiple along with 2019 operating profit projections, the valuation resulted in the following:

• Aerospace: $107 billion
• Elevator: $36 billion
• Building Systems: $52 billion

Total estimated value: $194 billion. After accounting for net debt and other liabilities amounting to $39 billion, the SOTP valuation stood at $155 billion.

Distinguishing SOTP from Discounted Cash Flow (DCF)

While both SOTP and DCF are essential valuation tools, they serve different purposes. SOTP can include parts of DCF analysis when determining the value of individual business segments. In contrast, DCF focuses solely on the future cash flows' present value to assess a project, business, or investment's worth.

Limitations of SOTP Valuation

Though SOTP valuations provide valuable insights, they come with limitations:

• Complexity in Valuation: Valuing several business segments increases the complexity of the analysis and the potential for errors or inconsistencies among different methodologies.
• Tax Implications: SOTP does not consider tax repercussions, particularly those associated with spinning off business units, which can impact overall value assessments.

Conclusion

The Sum-of-the-Parts Valuation is a powerful analytical approach that provides a holistic view of a company's worth by examining the value of each segment. By understanding SOTP, investors and analysts can better navigate corporate valuations, particularly for diversified businesses. For those looking to deepen their understanding of different valuation methods, it may be beneficial to explore resources on selecting the right approach based on specific company characteristics and market conditions.