# Sum of the Parts – SOTP Valuation Complete Beginner’s Guide

SOTP or Sum of Parts Valuations technique is one of the most efficient technique to value a conglomerate with unrelated business segments. In this article, we look at what SOTP means and how it is used to value a conglomerate with practical examples.

For understanding the below discussion on Sum of Parts, you should be aware of common valuation techniques like Enterprise Value and Equity Value Multiples and Comparable Company Analysis. You may wish to revise these concepts here-

## What is Sum of Parts – SOTP Valuation?

Most large companies operate in more than one business. Valuing a diversified company requires separate valuations for each of its businesses and for the corporate headquarters. This method of valuing a company by parts and then adding them up is known as SOTP or its full form Sum of the Parts valuation and is commonly used in practice by stock market analysts and companies themselves. (Simple :-))

Investopedia’s definition of Sum of Parts –

Valuing a company by determining what its divisions would be worth if it was broken up and spun off or acquired by another company.

## Sum of Parts – SOTP Valuation simplified

Let us understand Sum of the Parts valuation using an example of a large conglomerate company (ticker MOJO) operates the following business segments

### SOTP Valuation of MOJO Corp

The common valuation techniques are Relative Valuations, Comparable Acquisition Analysis and the Discounted Cash Flow approaches. These techniques can be applied to value MOJO Corp, however, before we do so, let us answer the questions below –

#### Should you apply Discounted Cash Flow Approach to Value MOJO?

• Yes, you can. However, if you do so, valuation would be technically INCORRECT.
• Reason – You can use DCF Financial Modeling to value segments like Automobiles, Oil and Gas, Software and Ecommerce. However, Banks are typically valued using the Relative valuation approach (usually Price to Book value) or Residual Income Method.

#### Should you apply Relative Valuation approach to value MOJO?

• Yes, you can do so. But do you think a single valuation methodology like PE Ratio, EV/EBITDA, P/CF, Price to book Value etc is appropriate to value all the segments. Obviously, this would again be technically INCORRECT.
• Reason – If Ecommerce segment is unprofitable, applying a blanket PE multiple for valuing all segments will not make much sense. Likewise, banks are correctly valued using Price to Book value approach than the other available multiples.

#### What is the solution?

The solution is to value the different parts of the business separately and add the values of the different parts of the business together. This is a sum of parts or SOTP valuation.

#### How do we apply Sum of Parts valuation in the case of MOJO?

In order to value the conglomerate like MOJO, one can use different valuation tools to value each segment.

• Automobile Segment Valuation – Automobile Segment could be best valued using EV/EBITDA or PE ratios.
• Oil and Gas Segment Valuation – For Oil and Gas companies, the best approach is to use EV/EBITDA or P/CF or EV/boe (EV/barrels of oil equivalent)
• Sotware Segment Valuation – We use PE or EV/EBIT multiple to value Software Segment
• Bank Segment Valuation – We generally use P/BV or Residual Income Method to value Banking Sector
• E-commerce Segment – We use EV/Sales to value E-commerce segment (if the segment is not profitable) or EV/Subscriber or PE multiple

If you are new to Relative valuation methodologies, you can read the following articles to enhance your learning on valuations –

## Sum of the Parts – SOTP Valuation Example – ITC Ltd

Let us apply SOTP on ITC Ltd, which is a large conglomerate based in India. ITC has a diversified presence in Cigarettes, Hotels, Paperboards & Specialty Papers, Packaging, Agri-Business, Packaged Foods & Confectionery, Information Technology, Branded Apparel, Personal Care, Stationery, Safety Matches and other FMCG products.

While ITC is an outstanding market leader in its traditional businesses of Cigarettes, Hotels, Paperboards, Packaging and Agri-Exports, it is rapidly gaining market share even in its nascent businesses of Packaged Foods & Confectionery, Branded Apparel, Personal Care and Stationery.

As each of ITC’s businesses is vastly different from the others in its type, the state of its evolution and the basic nature of its activity, the challenge for analysts, therefore, lies in fashioning a model that addresses value for each of its unique businesses and then arrive at a value for the Company as a whole.

Below are the segment details of ITC

(p.s. The data taken is from 2008-09 annual reports and does not reflect the current performance of breakup of ITC Ltd Segments. This case study of ITC valuation should only be used for educational purpose and does not be construe any kind of an Investment advise)

Let us apply Sum of Parts – SOTP Valuation approach here

### Segment 1 – Cigarette Segment Valuation

Cigarette is the core business of ITC and the major revenue contributor. It contributes more than 65% to the total revenues generated and 68% of profits is generated by this segment only.

##### Step 1 – Understand the Key Characteristics of Cigarette Segment
• ITC’s monopoly status within the cigarette industry
• ITC’s volume growth of 3.7% has been twice that of the industry in the past 15%
• Faster growth considering low cigarette penetration.

#### Step 2 – Choosing an appropriate Peer Group – Indian Peers

• Godfrey Philips: Strong player in the middle price segments
• VST Industries: Lower end in the market
• GTC Industries: Lower end in the market

The data below reflects the market share and value share of this segment.

#### Step 3 – Comparable Company Valuation Analysis for these Indian peers.

Practical Problem in identifying peers As you can see from the above charts that ITC has a clear monopoly in Cigarette segment (both volume as well as value share). How can we compare the valuation of ITC segment with the valuation of much smaller peers? With this we should look for global peers who may be of similar size.

#### Step 4 – Choosing an appropriate Peer Group – Global Peers

Below is the list of Cigarette Segment global peers and their valuation multiples –

##### Step 5 – Identifying the Most suitable valuation methodology

Most appropriate valuation multiple for valuing ITC Cigarette Segment is P/E or EV/EBITDA Multiple

#### Segment 2 – ITC Hotel Segment Valuation

Contributes only 8% to sales but approximately 18% contribution to EBIT.

#### Step 1 – Key Characteristics of Hotel Segment

• Asset intensive and has a long gestation period business.
• High Margins

#### Step 3 – Choose an appropriate valuation multiple

For valuing the hotel segment, valuation multiple approach like Enterprise value/room or PE or EV/EBITDA can be used.

### Segment 3 – Paper Segment Valuations

Paper and packaging segment contributes 5% of Sales and 10% to ITC’s EBIT.

#### Step 1 –  Note the Key Characteristics

• The paper industry is capital intensive and prone to global cycles.
• Indian Paper industry is fragmented
• Most Indian paper mills are small (98% of mills have a capacity of <50,000 tpa versus the ideal of 300,000 tpa)
• Large mills account for only 33% of output
• Asset intensive and has a long gestation period business

#### Step 2 – Identify the Key Comparables

No visible listed Indian Peer

#### Step 3 – Choose the appropriate Valuation Multiple

• Prefer P/BV as this segment is an asset intensive segment and no visible listed Indian Peer
• Benchmarking P/BV multiple to the average of the Global Peers may be the correct approach

#### Segment 4 – FMCG (Non Cigarettes) Segment

FMCG (non cigarettes) segment contributes 9% of Sales, however, this segment is unprofitable and results in EBIT Margin of -2%.

#### Step 1 – Identify the Key Characteristics

• Non-profitable, negative earnings

#### Step 3 – Choosing the Right Valuation Multiple –

• EV/Sales or P/Sales could be used to value the company

#### Segment 5 – Agriculture Segment Valuation

Agriculture segment contributes 11% of Sales for ITC and contributes 4% of EBIT.

#### Step 1 – Identify the Key Characteristics

• The earnings contribution of this business is very small (EBIT contribution is less than 4%)

#### Step 2 – Choose an appropriate Peer

• No publicly listed peer group available

#### Step 3 – Choose an appropriate Valuation Multiple

• Agriculture multiple should be based on the fact that it is a trading business
• We may use a PE multiple of 10x for valuing this agriculture commodity business.

### Summing it all together – Sum of Parts – SOTP Valuation of ITC

Below is the table that consolidates valuation of all 5 segments. Please note that the various scenarios are used to evaluate the fundamental value of ITC. For eg. If Global Peers (PE) is used for valuing FMCG segment, then the contribution to share price is Rs110/share. However, if you used Global Peers (EV/EBITDA) then the contribution would have been Rs105/share.

The final Sum of Parts valuation is =

Rs110 (FMCG-Cigarettes) + Rs21 (Hotel Segment) + Rs25 (FMCG – non cigarettes) + Rs15 (Paper and Packaging) + Rs3 (Agriculture Business) + Rs13 (Cash per share) = Rs187/share.

## Sum of the Parts – SOTP Valuation – Waterfall Charts

The analysis done using Sum of Parts look stunning once you use the Waterfall Charts to communicate the analysis to the clients. Below is the waterfall chart of ITC Ltd Sum of Parts Valuation.

## SOTP and Diversification Discount

Diversification discount also known as conglomerate discount, typically arises when you value a company using Sum of the Parts or SOTP. This happens due to multiple business segments being valued where there is not adequate information on business metrics and lack of management focus.

Diversification discount range from 10% to 30% generally. However, it may change significantly for specific countries. For example in India, diversification discount used for SOTP could be as high has 50%.

## Limitations of Sum of the Parts or SOTP

• Sum of parts or SOTP relies on adequate information provided for each segment. However, in most conglomerates, we note that sufficient information is not available to value each business segment.
• Segment valuation under SOTP depends on the stage of its business cycle. This information is sometimes very difficult to find out due to limited information availability.
• Another problem with Sum of parts is that there are various synergies and cost savings associated with a functioning of each segment when they operate as a part of a conglomerate. While evaluating the segment separately, the synergies and costs are not available.
• SOTP valuation can only be fully realized if the management decides to break-up the segments and run them as a separate company/unit. However, this becomes impossible as “company size” and management remuneration are generally closely linked and the spin-off may not in their personal interests.

## What’s Next?

If you learned something new or enjoyed the post, please leave a comment below. Let me know what you think. Thanks and take care.

1. By Imran on

Hi sir can you please explain how you arrived at the target price of each segment. This question is already being raised by one of the viewer

• By Dheeraj Vaidya on

Hi Imran,

Sorry for not making this clear in the post. As an example, if you look at Step 4, the average PE for Global Peers comes out to be 10.2x. Also, please note that to apply sum of parts, we also require EPS of each segment. With the EPS information of the segment, we can multiple this by 10.2 to find the fair price of that segment.

Hope it is clear nnow.

Thanks,
Dheeraj

2. By Akula on

Hi, Dheeraj, thanks very much for your sharing and it’s very good to learn from your website with step by step approach, pls advise what types of valuation multiples to use in comparing different industries / businesses ? Any guidelines on this as there are so many categories of industries / businesses, thanks a lot !

3. By Gaurav Gandhi on

Thank you for sharing the insights into valuations…I too have used EV/Sales, EV/EBITDA & P/E (with x-times bands) valuations.

However, i would like to know, beside Valuations, in Equity-research analysis (also for Project-finance/Debt-syndication), “Financial-projections/estimates” for future years are carried out. My lord, my question is “HOW WILL WE DERIVE THE GROWTH RATE?” I have observed that much of our final-opinion on stock/future-prospects is dependent on this GROWTH-RATE…I used to generally think Growth-rate is taken as lesser of these (conservative approach) :-
1. Industrial-growth rate OR
2. Using SUSTAINABLE GROWTH RATE (ROE*RETENTION RATIO) ie; Revenues will be increase for future years @ SUSTAINABLE GROWTH rate, Variable cost will vary according to sales, FC as it is, Working-cap will vary @ % of change in sales/Purchase, Cash-flows also to be worked out & put in prospective-B/s,…
I RATHER FOUND THESE THE MOST DIFFICULT EXERCISE, unless there is a DISCUSSION WITH THE MANAGEMENT about their future-expansion plans/Capacity-levels/Budgeted-sales & other figures available…Also, it becomes quite difficult when we work on Excel (without use of some Research-based software)

I, was however, rebutted when I gave an interview at CRISIL, they asked me certain thought-provoking questions : Won’t u adjust varying INFLATION RATES in ur cost for future? What about Foreign-exchange fluuctuations in future? I realized that ascertaining GROWTH RATE FOR FINANCIAL-PROJECTION cannot be given a straight-jacket formula or taking blindly industrial growth rate, but have to account various factors like Economic/Forex /Budgeted-levels from management/Future-expansion or ongoing acquisition…all these factors can widely change the GROWTH RATE & consequently, the whole analysis & outlook for the company.

I just want a guidance on how Large global-research/IB houses, project financials (including P&l,B/s,CFS) esp; w.r.t GROWTH RATE…Do they consider all such factors impacting growth (else, any wrong estimation will make the whole analysis worthless)

Please throw light on this as I have never gotten opportunity to work in big-houses.
– CA

• By Dheeraj on

Hi Gaurav,

Thanks for your note. You actually pointed out a very interesting debate on what growth rates to be taken. I have seen that each analyst in Investment Bank have their own understanding of growth rates and their own justification of taking such approach. My rule of thumb for growth rate is to take it as less than the GDP Growth rate of the company. If you take it higher than the GDP growth rate, then it is very easy to prove that the concerned company will outgrow the country in future.

You are right in pointing out that growth rates have significant effect on projections and valuations. It is therefore important to present the client with the sensitivity analysis of how your valuation changes with different growth rates. (obviously your assumption may not echo your client’s assumption and they may want to evaluate other scenarios).

Thanks,
Dheeraj

• By Gaurav Gandhi on

Thanks,
Gaurav Gandhi, CA

4. By Henry Ababio on

Great and evasive stuff explained and illustrated in very simple terms, Great effort!, thanks.

5. By Sudipta Saha on

The article is really insightful. I have a doubt- If I wanna do valuation of Titan do I need to apply SOTP? considering 80% of its business comes from jewelry, 15% from watch and rest from other segment. And both watch and jewelry are similar kind of businesses..consumer oriented discretionary spending

6. By Mayank on

Can you please also elaborate how to value a specific part of a business. For example, if a pharma company has generic and specialty products and within the specialty products, orthopedics is a sub-segment. Then how to value the orthopedic sub-segment.

7. By Rahul on

Can u please elaborate on why you have taken target multiple as 10x while the peers average is 10.2x? I understand its a small difference but why is it some rule? or u just wanted to be conservative?
Basically what is the difference between target multiple and industry multiple?

Lots of regards for such a nice explanation.

• By Wall Street Mojo on

Hi Rahul,

Thanks for your question. There is no specific reason for me to take 10x instead of 10.2x. You may take 10.2x to be precise.

Regards,
Dheeraj

8. By Ritesh on

Hi,

I would like to know how did you come up with the price of each segment and eventually add that up to get the price of the stock? I just couldn’t understand how cigarette’s business is priced at 110 and so on. Can you please explain it to me here or email me on chaingangritesh@gmail.com I am in dire need to know this.

9. By Rahul Alok on

Hi sir

Your blog is superb for the beginners, easy to understand and simple way used.

However in each valuation you have told the method to be used. I am stuck here with a question that why this type of valuation is used ( in each business segment in ITC ) ??

Regards

10. By sonal on

thank you sir… It is a very interesting posts & helpful to understand valuations. above valuations technique can be used on L&T like big entities for further understanding.

For what type decisions can the above charts & nos. be used from company & investor view point ???

11. By NILESH JAIN on

HELLO DHEERAJ SIR
FIRST OF ALL THANKS TO YOU
YOUR WAY OF PRESENTABILITY IS VERY CLEAR.
YOU ARE SHARING VERY KNOWLEDGEABLE INFORMATION ON SOTP.
I’M STARTING OUR CAREER IN EQUITY RESEARCH. THIS IS VERY HELPFULL FOR ME.
THANKS
NILESH JAIN

12. By Rakhi on

Dear Sir
Thanks for sharing this information with me.
This information surely helps me in my future.

13. By NASIR RAZA on

IT IS REALLY INFORMATIVE AND TECHNICAL EXPLANATION PRECISELY DEFINED WITH ILLUSTRATIONS
FOR THE CONVENTIONAL BANKERS AND VALUERS WHO ARE BIG HURDLE IN BUSINESS VALUATION.
MULTI SEGMENT BUSINESSES MOST OF THE TIME FACE WORKING CAPITAL REQUIREMENTS AND OUR CREDIT RISK MANAGERS USE THEIR THEORIES RATHER ANALYZING THE TOTAL BUSINESS STRENGTH OF A DIVERSIFIED NATURE OF BUSINESS.MOST OF THE BUSINESSES CLOSE DOWN THEIR LOW YIELD OR LOSS BUSINESS SEGMENT RATHER TO SUPPORT AND MAKE IT A PROFITABLE VENTURE.

14. By M.Ramanarayanan on

Dear sir
I am very happy to see your mail with illustrations.I am willing more learn and practice in the finance terminology.please reply.
Regards
M.Rama

15. By Suman on

Dear Dheeraj,

You article is very worth reading. But I have some confusion on selecting the right valuation multiples. Please provide me some more insights for selecting right valuation multiples.

Thanks
Suman

16. By Nalini on

Hey Dheeraj,

Your explanation was extremely useful, elaborate and easy to understand.

17. By rashmi on

Enjoyed reading… Thank you and please explain some more techniques of valuation.