Finance / Valuations · January 17, 2022

How To Value Stocks Using Sum Of The Parts (SOTP) Valuation Model

Introduction

Sum of the parts (SOTP) is a type of valuation model for valuing the overall valuations of the company by breaking the business model into several small entities or smaller business models.

These collections of business are valued independently and then clubbed to form a singular valuation model for the stock.

Mathematical representation

SOTP = (V1-D1) + (V2-D2) + (V3-D3) . . . (Vn-Dn)

Where

V1, V2 . . . Vn = The Gross value of the sub business in terms assets, revenue and profits

D1, D2 . . . Dn = The net debt in the sub business

The need to value stocks using SOTP model

Finding the valuation of a company can be a difficult task. A company has numerous assets under it’s name, the loans it takes to fund the business and the sources of revenue. It becomes a tedious task to monitor the overall well being of the company with just a bird eye view.

It is important to break down the entire business into smaller business and then treat this individual small business as an independent company altogether. Thus, summing up the individual valuations of all these businesses will give the overall valuation of the large business as a whole.

There are many a times these large cap companies acquire many smaller companies along their way. As and when they do so, their company valuations tend to change. The valuation of the company can go to positive or negative depending on the type of investment.

The SOTP valuation model provides to be helpful in determining the valuations of the entire company if it is in the process of buying / selling its sub businesses.

The principles of stock valuation using SOTP valuation model

There can be instances when the company as a whole has a big debt on it. Any valuer will identify this as a bad business as the company can go bust if the loan turns out to be a bad loan. Many a times this may not be the situation. A company in this case may take a loan to establish one leg of business and the rest businesses may run just fine.

For an investor, it showcases like as if the entire business is suffering the burden of a loan. A smart analyst can identify that business can be safe at a whole.

This valuation of such stocks using SOTP model can be helpful.

SOTP valuation model can also be used to find the valuations of companies when the firm is dealt with sub businesses that are different industries altogether, as the valuations for different businesses work differently.

A company valuation for a food industry may be completely different from that of an aviation industry.

The SOTP valuation can mostly be used in the following cases

  • Companies that are diversified into different sub businesses
  • Companies that are working as “Group of companies”
  • Valuations that require details of each sub business when buying / selling of those businesses

Let us understand with an example

Reliance Industries Limited

As you know, Reliance Industries as a whole has many sub businesses. If one goes to value the entire stock of RIL as a whole, it may give values that may not logically support the argument.

Let us try to identify the each business model under the umbrella of RIL (Data as of 2021)

Sr NoSub business
1Retail
2Digital services
3Media and entertainment
4Oil to chemicals
5Oil and gas E&P
Sub businesses of RIL (As of 2021)

From the following table, we understand the entire business structure of Reliance Industries by better understanding the sub businesses it has under it. We can also identify which of the sub business performs well and which one incurres losses.

Take for example, the digital services division of RIL is performing extremely well. But the oil and gas segment is not performing up to the mark and is incurring huge debt. When there is a demand for oil and gas, it looks as though RIL is sitting with huge consolidated profits. Does that mean that RIL will be a good investment for oil and gas?

The overall value of the company may be positive, but we need to also segment out the individual businesses under it to get the real picture.

Conclusion

SOTP (Sum of the parts) valuation model can also be clubbed with Discounted Cash flow model or other forms of valuation models for each division when a sub business is considered as a different company altogether.

Also one needs to understand that the SOTP model does not take the tax implications into consideration. The company as a whole pays one tax irrespective of the profits / losses the sub businesses tend to make.

Also Read 5 Effective Ways To Avoid Losing Money In Stock Market