- Private Equity
Sum-of-the-parts, or SOTP, is a modeling and valuation approach frequently used by bankers and investors. This guide will provide background on the methodology, cover how to employ it yourself, and just give you a real explanation of the term if you’re simply curious about the meaning of SOTP.
As previewed above, SOTP refers to the practice of segmenting businesses into different parts for the purposes of valuation or financial modeling. When employing this tactic, your model will have different builds for revenue and expenses across each of the ‘Parts,’ ultimately building to segment-level EBITDAs. From there, the sum of each of the segment-level EBITDAs will generally equal the EBITDA of the whole company (WholeCo).
We’ll cover this in more detail later, but these segments are also helpful to piece together individual valuations. You can apply different multiples (such as EV / EBITDA or other) to the financials of each segment to arrive at an isolated value for that business line. When added together, the sum of the individual values will be your estimate of the value of the WholeCo business.
SOTP is commonly used when you’re modeling or valuing a company with different business lines. This may be a large conglomerate, such as General Electric, or a smaller company that has a few different offerings.
In the General Electric scenario, it’s obvious that you will need different revenue and expense builds for each segment of the business. The company has (or had) offerings across aviation, healthcare, and financial services, among many others. Each of these will have totally different product offerings, revenue models, cost bases, and valuations.
To create an SOTP model and valuation for GE, you would build out financial models for the individual components, including valuations if desired, and sum them together to arrive at the WholeCo level (combined company and entire business).
The SOTP methodology is not limited to the largest multinational conglomerates (as some textbooks might have you believe). In reality it’s also hugely helpful for any business with disparate divisions or offerings.
Take the example of a local printing business. They do only two things, on-site document printing at a brick and mortar location, and online printer eCommerce.
An SOTP financial model of the document printing business will require analysis of foot traffic, print volumes, pricing by document type, cost of paper, rent, store employees, etc. Conversely, the eCommerce model will require a view on number of printers sold, price of the printers, cost of goods for the printers, warehouse space, online advertising expense, etc.
The most important point for this business will be the difference in value between the two segments. Say the physical printing business is quite a bit bigger in terms of both revenue and EBITDA.
In a normal model this would drive the value of the business in a proportional manner. However, investors and the market are much more excited about the faster growing, higher margin, scalable eCommerce business. This offering is more recent and has smaller revenue/EBITDA, but will drive outsize value in a transaction.
This dynamic is reflected by applying different multiples to each segment, say 8.0x EV / EBITDA for the physical printing and 15.0x EV / EBITDA for the eCommerce business.
Now that we’ve covered types of businesses where an SOTP approach is helpful, we can now talk about a few practical applications. Note that SOTP is helpful and used frequently in standard M&A and capital raising transactions, but these specific scenarios are even more tailored to the approach.
This section will cover some common best practices to ensure you build a great sum-of-the-parts model and valuation. Every scenario will be different, but these guidelines should be broadly applicable.
At the highest level, your Excel tab structure will become more important in an SOTP model. With multiple parts, you’ll need to make sure that your model is easy to navigate, both for yourself and for anyone else who looks at your work. The last thing you need is a disorganized mess — you’ll hate your life and be way more likely to make mistakes.
For simple models, keep each part isolated on different tabs, with revenue and expenses building to EBITDA for that segment. Each tab should be colored differently and obviously named appropriately.
For more complex models with advanced revenue and expense builds you’ll likely need multiple tabs for each segment. In this case, make sure they’re grouped together and all coded in the same color (use different colors for each segment).
Your model should have a consolidated view of the business with clear breakdowns of the different parts. This will most likely take the form of a consolidated Income Statement, with revenue, expense, and EBITDA subtotals reflecting the business lines included.
Generally, the valuation work should take place on one tab for all segments, Link in the various EBITDAs and make sure you clearly label everything. Not rocket science. Then make sure you have clear inputs for multiples (or other valuation drivers) across each of the segments. Show a per segment valuation, and then show a sum of the segment-level valuations as your WholeCo valuation.
Just don’t forget to subtract net debt and any non-operating items, then you’re good to go.
This should provide a helpful base to understand the meaning of SOTP modeling. It’s an incredibly useful methodology and worth spending time on. There is no doubt it will come up over and over again through your career, and can be a helpful tool in your toolkit.