Sum-of-parts gains currency as corporate valuation tool

MUMBAI: The analyst trying to crack the valuation code need not burn the midnight oil any more.

When good old tools like PE, P/BV, EV/EBIDTA and DCF failed him in his search for the best valuation tool, another one in the text book - SOTP, or sum of total parts — is coming to his rescue.

And there seems to be broad consensus among the analyst fraternity that SOTP is, by far, the best tool for valuing companies, especially those with diversified interests.

For example, if one were to value Bharti Airtel four years ago when it was making losses, the PE method would not have worked as there were no earnings.
The market saw potential in the stock, and, accordingly, valued it by discounting its future growth.

Insurance is another example. Since insurers, typically, starts making profits only from the seventh year of operation, it’s valued by a method called new business-achieved profit.

This way, analysts have valued ICICI Holdings (a mezzanine subsidiary for ICICI’s insurance businesses and mutual fund subsidiary) at over Rs 40,000 crore or $10 billion.

Reliance Industries is another example. Valuing the company, which is investing in businesses like retail and oil and gas exploration, among others, where profits are still to come, on a pure PE basis (given the commodity nature of its core business of refining and petrochemicals) will provide an incorrect picture.

This is where the SOTP comes into the picture. Simply put, SOTP values each of the businesses, based on relevant ratios and data (at times future growth projections), and at the end, totals each of the parts (including the original business) to arrive at an approximate value for the company.

An Edelweiss report on August 6, 2007, highlights that the SOTP technique looks credible as significant value exists in the balance-sheet, which may not be near-terms accretive.

The report says, “Applying the SOTP framework to a cross-section of companies, we see significant upsides to current earnings-based valuations.”  To understand this better, let’s take the case of ITC. ITC has a presence in cigarettes, hotels and paper, and is investing in businesses like foods and rural marketing that are in the early stages of growth.

Given that these businesses are at different stages of growth, does it make sense to value ITC entirely on a PE basis entirely? Not really. The SOTP method will be the ideal one here as well.

According to the report, balance-sheets of Indian companies have a lot of potential beyond obvious cash and cash equivalents. Historical costs and increase in real-estate prices are bringing into light assets which are needed to be valued separately.

Echoing the view, Shahina Mukadam, head of research, IDBI Capital, says, “The SOTP valuation is best for diversified companies where each business can be valued in the most suitable manner.”

For instance, if a company is engaged is fast-moving consumer goods, real estate and utility, it makes sense to value the FMCG business by dividing the enterprise value by EBIDTA, real estate by land banks and utility by discounted cash flow method.

After that, the value of each business can be added to arrive at the SOTP valuation. This would allow one to arrive at the appropriate value of each business. Valuing all companies by one method could be quite misleading.

Interestingly, this value can be unlocked by way of an IPO, demerger, or the sale of a minority stake to institutional investors or private equity firms.

The Edelweiss report says, “Equity markets are willing to look farther into the future (2009 and beyond) as the structural strength of growth story plays out.”

That’s because moves by Indian companies provide comfort and better earnings visibility over the longer term.

If one observes the trend in the best-performing stocks, it is visible that the market has been discounting the potential of their subsidiaries.

But the SOTP method has its share of critics, too. Deepak Jasani, head of retail research at HDFC Securities, says, “Such valuation tools come into focus when the markets are in a bullish phase and there is a lot of positive sentiment.”

Some others say that in a bearish phase such tools are hardly used. Says Manish Sonthalia, VP, equity strategy, Motilal Oswal, “It’s just another valuation technique and is not peculiar to any economic situation.”

Amitabh Chakraborty, president (equity), Religare Securities, says, “It is incorrect to say that one valuation method is better than the others. Valuation methods should be used on a case-by-case basis, though SOTP can be used in companies with diversified streams of earnings.”

Fair enough. So, till we hit upon a better method, let SOTP stay.