What it means
A single valuation multiple works well for a business with one clear line of activity. It works badly for a conglomerate, because a mature industrial division and a high-growth technology division deserve very different multiples.
Valuing them as one blended lump tends to undervalue the exciting part and overvalue the dull part. The method starts by splitting the company into its reporting segments, which the annual accounts usually disclose.
Each segment is valued using the approach that suits it best, most often a multiple of earnings before interest, tax, depreciation and amortisation (EBITDA), though a discounted cash flow or a revenue multiple can be used instead. The segment values are then added together to give the enterprise value, which is the value of the whole operating business.
To get from enterprise value to the value of the shares, you deduct net debt (borrowings minus cash) and any other claims such as minority interests. Dividing the result by the number of shares gives a value per share.
Investors then compare that figure with the current share price to judge whether the market is undervaluing the group. Practitioners often apply a conglomerate or holding company discount to the total, because running a mixed group carries central costs and can reduce focus.
Whether a discount is justified, and how large it should be, is one of the most debated judgements in the method. A bigger discount makes the group look less attractive as an investment.
The approach is most useful when someone is thinking of breaking the company up, selling a division or spinning it off. It also relies on good segment data, so problems arise when divisions share costs, assets or customers and the allocation between them is arbitrary.
The answer is only as reliable as the multiples and the cost allocations that go into it.
In practice
Real-world examples.
Example
An analyst covering an industrial group values its machinery division on a low multiple and its sensors division on a much higher one. The sum of the parts is well above the group's market value, so she tells clients the shares look undervalued.
Example
The board of a hotel and property company is asked by an activist investor to consider splitting the business. The finance team builds a sum-of-the-parts model to show what each side would be worth alone, and to test whether a split would actually create value.
Example
A private equity buyer is bidding for a food and packaging group. By valuing the packaging arm separately from the food brands, the buyer sees it could sell one division for a high price and keep the other, which supports a higher offer.
Formula
Calculation
Equity value = (segment 1 EBITDA x multiple 1) + (segment 2 EBITDA x multiple 2) + ... - net debt
Suppose a group has three divisions. Division A earns EBITDA of $40 million and deserves a multiple of 8, so it is worth 40 x 8 = $320 million. Division B earns $25 million at a multiple of 12, worth 25 x 12 = $300 million. Division C earns $15 million at a multiple of 6, worth 15 x 6 = $90 million. Enterprise value = 320 + 300 + 90 = $710 million. With net debt of $150 million, equity value = 710 - 150 = $560 million. With 50 million shares in issue, the value per share is 560 / 50 = $11.20.Case study
Seen in the real world.
Meridian Holdings is an illustrative, fictional group with a logistics arm, a printing business and a small payments technology unit. The shares traded as if the whole company were one slow-growing logistics firm.
The finance director built a sum-of-the-parts schedule in which logistics earned EBITDA of $60 million at a multiple of 7, printing earned $20 million at 5, and payments technology earned $8 million at 15. That gave 420 + 100 + 120, which is an enterprise value of $640 million.
After deducting net debt of $240 million, the equity was worth $400 million, well above the market's valuation. In this illustrative story, the board used the schedule to start selling the printing business and to give the payments unit its own reporting line, so that investors could see what each part was worth.
Watch out
Common mistakes.
- Using the same multiple for every division, which defeats the purpose of valuing the parts separately.
- Forgetting to subtract net debt and other claims, so that the total enterprise value is wrongly presented as the value of the shares.
- Ignoring shared central costs, which means the parts look worth more than they would be as stand-alone businesses.
Questions
People also ask.
When is sum-of-the-parts valuation most useful?
It is most useful for conglomerates and groups with very different divisions, particularly when a break-up, sale or spin-off is being considered.
Why might the total be worth more than the market value of the company?
The market may apply a single blended multiple, or a conglomerate discount, so the separate pieces can look more valuable than the whole.
Is sum-of-the-parts valuation exact?
No, it depends on judgements about multiples, cost allocation and discounts, so it should be shown as a range and tested against other methods.
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