Sum-of-the-Parts Valuation: When Can The Asset Be Considered Separately?

Usually, investors analyse a company as one singular entity based on their consolidated earnings, balance sheet and cash flows. While they aren’t wrong, one can gain a much more accurate valuation using a sum-of-the-parts (SOTP) valuation. For a company with different business segments, each segment would then be valued using ranges of multiples for that particular segment. Using such a method, it would give us a better understanding of the company and each division.

Vodafone does not consolidate Verizon Wireless and, as a result, sell-side analysts seem to ignore its significant value

– David Einhorn

By breaking down the company into its different business divisions, many a times, it would allow us uncover information like whether the group’s consolidated earnings are being dragged down by one business division. Looking at Sinwa Limited (SGX:5CN), the group’s consolidated earnings were being dragged down due to their engineering division. Upon cutting the loss making division, we see a turnaround in earnings and cash flows. Furthermore, a classic example of how a sum-of-the-parts valuation would be beneficial can be seen in the classic example of how Vodafone does not consolidate the financial results of Verizon Wireless. If one were to apply a holistic approach in valuing Vodafone, they would have ignored the value of a 45% stake Vodafone Group Plc (ADR) (NASDAQ:VOD) (LON:VOD) had in Verizon Wireless.

Whilst there is good reason in using a sum-of-the-parts valuation on companies, one has to understand the risk that comes along with such a valuation methodology. While breaking down the company into its different business divisions may yield a higher intrinsic value, not understanding how interconnected the divisions may be would result in an over-inflated number.

When can the asset be considered separately?

Using the example of Apple Inc. (NASDAQ:AAPL), amongst the various business divisions they have, two divisions they derive their revenue from would be selling hardwares (iPhone, iPad etc.) and the App Store. The problem that arises here when using a SOTP valuation would be the difficulty of valuing the sales of hardware and from the App Store individually. With the App Store built based on the hardwares, the former would cease to exist assuming people stop buying Apple Hardwares. That said, with sufficient caveats, it is still possible to value Apple based on a sum-of-the-parts valuation.

Also, assuming a retail company owning the real estate that they are operating in, can we value each component separately? Though not impossible, the two components are not truly independent of each other. In the event that the retail business is declining, the value of the real estate would be not as much as when the retail business is prospering. One may argue that the value of the land is independent of how well the business is doing. As cynical as it may seem, as a buyer knowing that the seller is desperate in selling their land to raise cash for their declining business, I would not offer a fair market value for it.

What is the catalyst in unlocking the value of the asset?

In the case companies with years of history, they may have purchased land back in the 90s or earlier when it was still cheap relative in today’s terms. Most often, such real estate would be shown as of their book value in the balance sheets and the company has not done a revaluation in a long time (e.g. OCBC, SingPost, HupSteel etc.). While such companies may be undervalued on their NAV, however, the question would be what is the catalyst in unlocking the value of such assets? Most often than not, management does not have any incentive in unlocking the value of such assets.

Professor Graham, you buy a stock for $10 and you say that the intrinsic value is $20, what are the forces that would eventually make people realise it’s worth $20 and it can actually get up to trading at $20? Graham’s response to Senator Fulbright at the time was that, he just said, Senator Fulbright, this is one of those mysteries that we do not know the answer to. But he said that, if we are right on the intrinsic value, in some reasonable period of time, it will trade around its value. 

The question of catalyst has been widely debated and even amongst value investors, each has their own personal view towards it. Some would consider value a catalyst in its own right. One great example that comes to mind would be PNE Industries Ltd (SGX:P07). I remember reading a blog post on PNE Industries about how it lacked a catalyst for Mr. Market to price it fairly. Looking at the past 2 months or so, shareholders invested in PNE over the years would have enjoyed the recent run up in prices. Hence, my personal take would be not to place too much an emphasis on searching for a catalyst in unlocking the value of assets.

Conclusion

While a sum-of-the-parts valuation does provide us with more in-depth information on the company, one has to be careful when analyzing the different parts. Sometimes, investors in their attempt to create a SOTP opportunity, slice the company into too many parts without understanding the interconnectedness of divisions, results in an over attractive investment opportunity. Furthermore, a key investing principle to me would be to keep things simple.

You don’t have to know a man’s exact weight to know that he’s fat

– Benjamin Graham