When analysts track a large company like the energy giant Reliance Industries, they use a valuation method called sum of the parts or SOTP. It is a commonly used method across the world.
Here are four things you need to know about SOTP analysis:
Simply put, the SOTP method follows a principle of 'divide and unite'. This analysis initially values each individual business of a diversified company. Later, all businesses are clubbed together to calculate the total value of the diversified company. Take for instance, Reliance Industries (RIL). Main businesses of the company are oil refining and petrochemicals. These businesses account for two thirds of their revenue and 85% of profits. The company has also diversified into oil and gas exploration, retailing and recently telecom. The SOTP method uses future profits of businesses for assigning a value. Kotak Securities put a SOTP value of Rs 1051 per share for Reliance Industries businesses. This is based on expected profits at the end of financial year 2016-17.
The SOTP valuation of RIL is estimated at Rs 1051 per share for the financial year ending March 2016-17, according to a Kotak Securities report. The valuation was estimated based on expected earnings before interest, tax, depreciation and amortization or EBITDA each business is expected to report. Kotak Securities expects the flagship refining business of Reliance to clock an EBITDA of Rs 27,000 crore. Our analyst gives 6.5 times multiple to this expected number. This puts the enterprise value of the flagship refining business at Rs 1,75,800 crore. This value is divided by number of shares outstanding of Reliance Industries. The SOTP value for the refining business comes to Rs 597. Similarly, enterprise value is calculated for petrochemicals, telecom, retail and investments. The total enterprise value of all businesses is then subtracted by the net debt outstanding in the group to arrive at the SOTP value of Rs 1,051. The current price of Reliance Industries is Rs 987.
The SOTP approach gives the analyst the liberty to choose an appropriate valuation that suits the particular sector in focus. This is because each business has its own peculiarities. Each industry produces goods that are different from the rest. Each sector has different levels of profitability. So, it is not feasible to apply the same yardstick for every business.
Undervaluation of the shares of a conglomerate is a perennial problem. This refers to a situation when the stock market values the assets of the diversified company at less than the estimated sum of the part. On most occasions investors like companies that have a focus. The price to earnings multiple of conglomerates tends to be lower than companies that focus on a single business.
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