Sum of Parts Valuation - Explained
What is a Sum of Parts Valuation?
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Table of ContentsWhat is a Sum-of-the-Parts Valuation?How Does a Sum-of-the-Parts Valuation Work?What Does the SOTP Tell You?Example of How to Use the Sum-of-the-Parts Valuation SOTPThe Difference Between the SOTP and Discounted Cash Flow DCFLimitations of Using Sum-of-the-Parts Valuation SOTP
What is a Sum-of-the-Parts Valuation?
The sum-of-the-parts valuation (SOTP) refers to a method of valuing a firm by evaluating or assessing each of its divisions separately before their values are aggregated. This means that all the divisions or segments of the business are evaluated distinctly and then summed up to realize the value of the firm. SOTP is used to determine the equity of a company, it entails valuing all its business entities before a single total enterprise value (TEV) is arrived at. SOTP provides an insight into the value of a firm if its units or divisions were to be taken over by another firm.
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How Does a Sum-of-the-Parts Valuation Work?
To calculate the Sum-of-the-Parts Valuation of a company, the formula below will be used;
SOTP Valuation = Value of Segment N1 + Value of Segment N2 + + NDNL + NA
In the formula above, ND means net debt, NL means non-operating liabilities while NA refers to non-operating assets. Using the above formula, the value of each of the business is derived separately first before they are aggregated or summed up to realize the value of the firm or company as a whole. When calculating the SOTP of a company also, the net debt, non-operating assets, and nono-operating liabilities/expenses need to be adjusted. There are different analysis methods that can be used when calculating SOTP, one of these methods is the discounted cash flow (DCF).
What Does the SOTP Tell You?
Oftentimes, Sum-of-parts valuation is used for large companies with many divisions or business units. Sum-of-parts valuation indicates the value of a firm through the summation of the values of all its divisions, sublets or parts. SOTP aids the understanding of the true value of a company by sizing up/valuing all its parts. The Sum-of-parts valuation is otherwise called the breakup value analysis. SOTP tells us the value of each part of a company, as against the value of the firm as a hole. If a firm is acquired or sold without a SOTP, it could mean selling the firm cheaper than its true worths or lesser than the sum of its parts. Some essential points you should know about Sum-of-parts valuation are;
- Sum-of-parts valuation is a method of determining the true value of a company through an aggregate of the value of its parts or divisions, it entails knowing the worth of a company by valuing the worths of its parts.
- SOTP helps to know the true value of a company, it is often used for large companies.
- SOTP can also be used when a company is to be restructured, evaluated or revalued.
- Breakup value analysis is another term for Sum-of-parts valuation (SOTP).
Example of How to Use the Sum-of-the-Parts Valuation SOTP
If Company ABC which is a large company with different divisions or business units is to undergo restructuring, the Sum-of-parts valuation (SOTP) can be used. All its parts will be valued separately before their sum is aggregated to determine the true value of the company. If for instance, the entire company is valued at $675, it is the sum of the value of its different divisions and units.
The Difference Between the SOTP and Discounted Cash Flow DCF
The discounted cash flow technique is a method of valuation in which the discounted future cash flows of a business are used in the valuing of the business. DCF is also applicable to the valuing of the future cash flow of a business segment, division or project using a discount rate. In most cases, DCF is a valuation tool that is incorporated into Sum-of-parts valuation (SOTP), it is used to determine the value of the segments or units of a business.
Limitations of Using Sum-of-the-Parts Valuation SOTP
Despite the uses of the Sum-of-parts valuation (SOTP), it has certain limitations or drawbacks. The major limitation of the Sum-of-parts valuation (SOTP) is that it is a rigorous process that requires many inputs. To value the different parts of a business, several inputs are needed and this is really demanding. Another limitation of the Sum-of-parts valuation (SOTP) is its failure to account for tax implications, this method gives no consideration for tax.