INVESTOR LETTER #110
Sum of the Parts (SOTP)
Sum of the Parts (SOTP) is a valuation method used for companies that operate multiple different businesses. Instead of valuing the company as one single entity, investors value each business separately and then add them together to estimate the company's total intrinsic value. This approach is especially useful for conglomerates because different businesses often deserve different valuation multiples.
INVESTOR NOTE
A business owner thinks in decades. A speculator thinks in minutes.
Selling a Family Home
Imagine a family owns a large piece of land with a house, a small shop, a warehouse, and an empty plot that can be developed in the future. If someone asked, 'What's this property worth?', you probably wouldn't value everything as one single asset. You'd estimate the value of each part separately and then add them together. Businesses can be valued in exactly the same way.
Why One Company Can Contain Many Businesses
Some companies don't operate just one business. They may own a cement division, a software business, a financial services company, renewable energy assets, and listed investments. Since each business has different growth rates, risks, and profitability, using one valuation method for the entire company may produce misleading results.
What Is Sum of the Parts?
The Sum of the Parts method values each major business or division independently. After estimating the value of every segment, investors add them together and adjust for debt, cash, or other assets to estimate the company's overall value.
Not Every Business Deserves the Same Multiple
Imagine two divisions inside the same company. One is a fast-growing software business, while the other is a mature manufacturing business. It wouldn't make sense to value both using the same valuation multiple because investors typically value software and manufacturing companies very differently.
Hidden Value Can Stay Hidden
Sometimes an excellent business is buried inside a large conglomerate. The market focuses on the weaker divisions and ends up undervaluing the stronger ones. SOTP analysis helps investors identify these situations by valuing each business on its own merits.
Some Parts Grow Faster Than Others
A company's mature division may barely grow, while another division could be expanding rapidly. Looking only at the combined financial statements may hide these differences. Separating the businesses often gives a much clearer picture of where future value is being created.
It's More Than Just Adding Numbers
SOTP isn't simply an accounting exercise. Investors must first understand each business, choose an appropriate valuation method, estimate reasonable multiples or cash flows, and only then combine the results. The quality of the analysis depends entirely on the quality of the assumptions.
Conglomerates Benefit the Most
The SOTP approach is commonly used for diversified holding companies, conglomerates, companies with separately listed subsidiaries, and businesses operating across unrelated industries. It is much less useful for companies that operate only one core business.
Don't Forget Debt and Cash
After valuing all the operating businesses, investors still need to consider the company's overall debt, excess cash, investments, and other assets. Ignoring these items can lead to an incorrect estimate of intrinsic value.
Simple Doesn't Mean Easy
Although the idea behind SOTP is straightforward, accurately valuing each business segment requires deep understanding. Investors need to study industry economics, growth prospects, profitability, and comparable companies before assigning values.
Use SOTP as a Cross-Check
Experienced investors rarely rely on only one valuation method. They often compare the results from SOTP with DCF analysis, P/E multiples, EV/EBITDA, and other approaches. If several methods point toward a similar valuation, confidence in the estimate usually increases.
One Question Before Valuing a Conglomerate
Whenever you analyze a company with multiple businesses, ask yourself: 'If these divisions were independent companies, would I value them all the same way?' If the answer is no, you've probably found a situation where the Sum of the Parts approach can provide a much more accurate estimate of intrinsic value.
INVESTOR PRINCIPLE