Sum of parts how-to

A sum of parts valuation is not really any more difficult than any other approach, although it is more work because each component has to be valued separately.

Decide segments and gather data

The first step is to decide how to split the company into component businesses. You are constrained by what information is disclosed. Most companies that are complex enough to require the use of a sum of parts provide at least some segmental reporting in the accounts. The different businesses may belong to separate subsidiaries or associates with their own accounts — if you are really lucky, there may be associates that are separately listed, giving you full disclosure.

In some cases you may find that that you can simplify by combining segments, especially smaller ones that have similar characteristics. In othes you may find that the disclosed information is insufficient to separate the segments you want to.

Valuation

You now need to decide how to value the different components. This is no different from the usual decision of which valuation approach to use, except you need to make the decisions several times: once for each component.

You now come to the first step that may require looking at things a little differently. You cannot easily add together valuation ratioa. Reverse things and use the level of the ratio that you think the business deserves to calculate a value: for example, if you think PE would be the most appropriate valuation ratio, then multiply the EPS by what you think the PE should be to get a share price, and then multiply by the numbers of shares in issue. In fact you would shorten this particular calculation by multiplying what you think the PE should be by the bottom line profit.

To determine what a valuation ratio should be, look at similar businesses you think are fairly priced, or look at the market or sector and adjust for any differences in growth or risk. This should not be an innsurmountable barrier as you would have to determine (at least implicitly) some level at which the ratio would be high or low anyway.

If any of the components are separately listed businesses, that gives you the option of using their market value. This is quick and easy. However, your own valuation may value it very differently. Using market value is probably a good approach for small components that you are reasonably confident the market has got right, but not a good idea for a business that generates half the profits and over which opinions of appropriate rating are likely to vary greatly.

When valuing subsidiaries and associates it may sometimes be approrpiate to add a premium for control (outright or effecive).

Adding it up

This is fairly easy: it is largely a matter of simple addition. However there are a few things you need to remember:

  • Pro-rate the value of partly owned businesses (subsidiaries, associates, and joint ventures).
  • You cannot simply add enterprise values to equity values. It is probably best to deduct the debt and other relevant liabilities from each EV first to get equity values.

Once you have done this you can compare what you think the market cap ought to be to what it actually is.

Copyright Graeme Pietersz © 2005-2019