Part 2 – Lesson 12
Sum of the parts is a valuation methodology that entails valuing each of the underlying pieces of a business separately and then adding them together, rather than valuing the entire cash flows of the company. Sum of the parts is useful for companies that operate business divisions that would normally be valued using trading multiples (or discount rates) that are quite different from each other due to the distinctness of each business division.
For example, let’s assume that Company A operates Subsidiary B and Subsidiary C. Subsidiary B is a retail shopping center business (owns retail shopper center and leases it out), whereas Subsidiary C is a shoe retail business. These are two very different businesses: real estate vs. retail. Real estate companies are typically valued based on cap rate (which can essentially be thought of as a simple DCF) while the retail business may be valued based on an earnings multiple.
It would make little sense to combine the cash flows of Subsidiary B and Subsidiary C and value the combined cash flow with a single DCF or a single valuation multiple. These two subsidiaries likely deserve to be valued at very different discount rates, so it makes more sense to value each “part” of the business separately and then “sum” them together.
Sum of the parts is used not just in situations where the underlying segments are in a different line of business. But it is also used to showcase the value of underlying business segments when the value of one of the business segments is not being adequately valued in the broader organization. For example, let’s assume Company B is a manufacturer of garden hoses and potting soil. Let’s assume the garden hose segment is growing at 20% a year and makes up for 100% of the Company B’s profits. Let’s also assume that the potting soil segment is declining 10% a year and is losing money for Company B. If we were to value Company B as a whole, an investor may ascribe a relatively modest multiple to the entire business since the profitability of the garden hose segment is being masked by the potting soil segment.
Instead, if an investor were to separate the financials of the two segments and value each piece separately, it may show how value could be unlocked if Company B were to sell or separate one of the segments.
Example – Company B Sum of the Parts
Let’s build on the example about Company B. Below is simple sum of the parts analysis of Company B’s segments: the garden hose segment and the potting soil segment (Part 2 Excel Download):
Let’s review a few observations from the sum of the parts analysis:
When Company B combines the financial results from the garden hose segment and the potting soil segment, the total company EBITDA growth is only in the 5-7% range, which masks the great underlying performance of the garden hose segment. For a modest growth EBITDA company, investors may value the business at a modest 7x EBITDA multiple. You may wonder where we pulled the 7x EBITDA multiple from. This is simply based on our experience of observing typical EBITDA multiples at certain levels of growth.
When we create a sum of the parts valuation, we will assign an EBITDA multiple valuation (or earnings or cash flow multiple) to each underlying business segment including corporate overhead. We have assigned a 9x EBITDA multiple to the fast growth garden hose segment. Based on our experience, businesses that grow EBITDA in the 20% range are typically rewarded with high EBITDA multiples. In fact, 9x EBITDA for a 20% growth business is likely conservative. We have also assigned a 0x multiple to the potting soil business, which makes the underlying assumption that the potting soil business is worth nothing. Thought of another way, this sum of the parts shows the potential value of the company if the potting soil business were simply shut down.After calculating the total enterprise value of the business by summing the individual segments, then, we subtract the net debt of the company to come to the equity value.
The sum of the parts analysis shows that the equity value of Company B could be $3,325 if evaluating each part of the business separately, which is significantly higher than the $2,125 value when valuing the total company together. This type of analysis is often employed by the management teams to assist in decisions on whether they should sell / spinoff / shut down a specific business segment.A prudent manager of Company B would recognize that significant equity value could be created by simply shutting down the potting soil business (or selling it if possible).