Sum-of-the-Parts Valuation

Imagine you're looking at a sprawling mall in the heart of Mumbai. It’s not just one store but multiple departments — clothing, electronics, food court, a movie theatre, and more. Each of these sections has its own value, revenue model, and growth potential. Rather than valuing the mall as one single entity, you might value each department individually, based on its performance and outlook, and then add them all up to get a fair value of the entire mall. This approach is similar to Sum-of-the-Parts Valuation (SOTP) — a method that values a company by assessing each business segment or subsidiary separately and then combining them to arrive at the total company value.

What is Sum-of-the-Parts Valuation?

Sum-of-the-Parts Valuation is an approach used to value a company that operates in multiple, often unrelated, business segments. Instead of applying a single valuation multiple to the company as a whole, each segment is valued individually using appropriate multiples for its industry. The values of these individual parts are then added together to estimate the total value of the company.

This method is particularly useful for conglomerates or diversified companies like Tata Group or Adani Group, which have multiple, distinct businesses — from energy and infrastructure to consumer goods and technology.

Why Use Sum-of-the-Parts Valuation?

SOTP is most useful when a company operates in very different sectors, making it difficult to apply a single valuation multiple across the entire business. Each division may have different growth prospects, risks, and profitability, so treating them separately helps provide a more accurate valuation. How Does SOTP Work?

1. Identify the Business Segments: The first step is to identify the key business segments or subsidiaries of the company. These can be different industries or product lines that are distinct from each other.
   

2. Assign Appropriate Valuation Multiples: For each segment, select the most suitable valuation multiple based on the industry it belongs to. For example, you might use a P/E ratio for a consumer business, EV/EBITDA for an industrial business, and P/B ratio for a real estate segment.
   

3. Calculate the Value of Each Segment: For each segment, apply the selected multiple to its financial metrics (earnings, revenue, or assets) to estimate its value.
   

4. Sum the Values: Add up the values of all the segments to arrive at the total value of the company.
   

Formula for SOTP: Total Company Value = Value of Segment 1 + Value of Segment 2 + ... + Value of Segment N

Example:

Consider Bajaj Auto, which operates in the motorcycle and auto parts business. You may have two business segments:

1. Motorcycle Division: Estimated value based on EV/EBITDA multiple: ₹30,000 crore.
   

2. Auto Parts Division: Estimated value based on P/E ratio: ₹10,000 crore.
   

So, to calculate the total company value:

Total Company Value = ₹30,000 crore + ₹10,000 crore

Total Company Value = ₹40,000 crore

The total company value of Bajaj Auto would come to Rs 40,000 crores.

Advantages of SOTP:

• Accurate for Diversified Companies: SOTP allows for a more nuanced valuation of companies that operate in various industries.
  

• Reflects Sectoral Differences: By valuing each segment separately, you can account for the different growth rates, risks, and capital requirements of each division.
  

• Clearer Picture of Value: SOTP provides investors with a clearer understanding of the value of individual business units and how they contribute to the overall company.
  

Limitations of SOTP:

• Requires Detailed Information: SOTP requires a deep understanding of each business segment, including accurate financial data and the right multiples for comparison.
  

• Over-Simplification: Sometimes, breaking down a company into parts may oversimplify the dynamics of how these segments interact with each other.
  

• Not Suitable for Homogeneous Companies: For companies that operate in similar sectors or have highly integrated businesses, SOTP may not add much value over simpler valuation methods like DCF or market comparables.
  

SOTP is particularly useful for conglomerates like Tata Group, Adani Group, or Mahindra Group, which have a variety of business units in different sectors such as energy, auto, IT, and consumer goods. For example, Tata Motors may be valued based on SOTP by evaluating the value of its automobile segment, its stake in Jaguar Land Rover, and other subsidiaries separately.

The Sum-of-the-Parts method offers a more granular approach to valuing diverse businesses. By assessing each division individually, it provides a more accurate picture of the company’s true worth, especially for complex conglomerates. In the next chapter, we will discuss Economic Value Added (EVA) — a measure of a company's financial performance that focuses on how much value it adds beyond its cost of capital.