Understanding SOTP Valuation and its importance for conglomerates

The Sum Of The Parts (SOTP) valuation or breakup value analysis is an approach to evaluate a firm by separately assessing the value of each business segment or subsidiary and adding them up to get the total value of that company. It is generally used with various valuation techniques such as Discounted Cash Flow (DCF) modelling and comparable company analysis. 

In simple terms, it is a process to determine the worth of a company by calculating the cost of each aggregate division, assuming they were to be spun off or acquired by a different company. 

Formula for SOTP Valuation

SOTP = N1 + N2 + ND – NL + NA 

Where, 

N1 = Value of the first segment 

N2 = Value of the second segment 

ND = Net Debt 

NL = Non-operating liabilities 

NA = Non-operating assets 

To start, we have to determine what the appropriate business segments should be, in order to value the firm. Many companies report segmented information, which makes things easier. For example, in the case of ITC, the company operates through four segments: FMCG; Hotels; Paperboards, Paper and Packaging, and Agri-Business. The performance of each of these business divisions is reported separately. It may take some deeper digging to get a breakdown of performance across different parts of the company. 

Once, we know the various segments, we value each segment is derived separately using various analysis methods. For example, the discounted cash flow, asset-based valuation, and multiples valuations using revenue, operating profit or profit margins are methods utilized to value a business segment. The final step is to add up all the segments to arrive at the final valuation. 

When to Use SOTP Valuation 

SOTP valuation is very useful for some companies, but not for others. Below is a list of examples of when this type of analysis is useful, and when it isn’t.