Intro to Finance: Valuation - Sum-of-the-Parts SOTP Valuation

What This Is

Sum-of-the-Parts (SOTP) valuation is a method used to estimate the value of a company by breaking it down into its individual components, such as operating segments, subsidiaries, or assets. This approach is particularly useful when a company has diverse business lines or significant non-operating assets. For example, consider Apple Inc., which has a consumer electronics segment, a services segment, and significant cash and investments. By valuing each segment separately, we can estimate the total value of the company.

Key Formulas & Symbols

• SOTP =? (Segment Value) + Non-Operating Assets Value where SOTP = sum-of-the-parts value, Segment Value = value of each operating segment, and Non-Operating Assets Value = value of non-operating assets.
• Segment Value = (EBITDA x (1 - Tax Rate) x (1 + Growth Rate)) / (Cost of Capital) where EBITDA = earnings before interest, taxes, depreciation, and amortization, Tax Rate = corporate tax rate, Growth Rate = expected growth rate, and Cost of Capital = weighted average cost of capital.
• Non-Operating Assets Value = (Market Value - Operating Assets Value) where Market Value = market value of the company, and Operating Assets Value = value of operating assets.
• WACC = (E x Rf) + [(D x Rd) x (1 - Tax Rate)] where WACC = weighted average cost of capital, E = market value of equity, Rf = risk-free rate, D = market value of debt, Rd = risk-free rate of debt, and Tax Rate = corporate tax rate.
• Cost of Capital = WACC = (E x Rf) + [(D x Rd) x (1 - Tax Rate)] where Cost of Capital = weighted average cost of capital.
• Terminal Value = (FCF x (1 + g)) / (r - g) where FCF = free cash flow, g = expected growth rate, r = cost of capital, and Terminal Value = terminal value of the company.
• Discount Rate = WACC = (E x Rf) + [(D x Rd) x (1 - Tax Rate)] where Discount Rate = weighted average cost of capital.

Step-by-Step Calculation

1. Identify the company's operating segments and non-operating assets.
2. Estimate the EBITDA, tax rate, growth rate, and cost of capital for each segment.
3. Calculate the segment value using the formula: Segment Value = (EBITDA x (1 - Tax Rate) x (1 + Growth Rate)) / (Cost of Capital).
4. Calculate the non-operating assets value by subtracting the operating assets value from the market value of the company.
5. Sum the segment values and non-operating assets value to estimate the SOTP value.

Common Mistakes

• Mistake: Using book value instead of market value for WACC.
• Correction: Use market value to reflect the company's current market position.
• Mistake: Confusing IRR and NPV ranking.
• Correction: IRR is the rate at which the NPV equals zero, while NPV ranking is the ranking of projects based on their NPV.
• Mistake: Not considering the impact of taxes on the cost of capital.
• Correction: Taxes can significantly impact the cost of capital, especially for companies with high debt levels.

Exam / CFA Tips

• Be prepared to calculate WACC and cost of capital using different scenarios.
• Understand the difference between IRR and NPV ranking.
• Be able to identify and calculate the terminal value of a company.
• Practice estimating the SOTP value using different company scenarios.

Quick Practice Problem

Problem: Estimate the SOTP value of Tesla Inc. using the following information:

• EBITDA: $10 billion
• Tax Rate: 20%
• Growth Rate: 10%
• Cost of Capital: 8%
• Market Value: $500 billion
• Operating Assets Value: $200 billion

Answer: SOTP value = $150 billion + $300 billion = $450 billion.

Last-Minute Cram Sheet

• The SOTP method assumes that the company's segments are independent and can be valued separately.
• The SOTP value is a weighted average of the segment values and non-operating assets value.
• The cost of capital is a critical input in the SOTP valuation model.
• The terminal value is estimated using the FCF and expected growth rate.
• The SOTP method is sensitive to changes in the cost of capital and growth rate.
• The SOTP value is a comprehensive estimate of the company's value.
• The SOTP method assumes that the company's segments are valued at market value.
• The SOTP value is a useful tool for estimating the value of companies with diverse business lines.
• The SOTP method is not suitable for companies with significant intangible assets.