How a Sum-of-the-Parts approach can give investors a valuation edge

In the 1990 film Pretty Woman, Richard Gere’s character Edward Lewis explains that his wealth comes from buying up troubled businesses and splitting them up. By selling the component parts separately, he can generate a profit on the price paid for the whole business.

This leveraged strategy is often referred to as asset stripping and is not a suitable approach for the average private investor.

However, I think the sum-of-the-parts (SOTP) valuation approach implied by Lewis’s strategy can be a useful addition to an investor’s toolkit. It can be relatively simple to use, too.

In its simplest form, SOTP involves identifying elements of a business – assets or business operations – that could potentially be separated into discrete units for sale or independent operation.

Each element is then valued independently using techniques such as discounted cash flow, profit multiples or market pricing of tangible assets.

The sum of these valuations gives us an SOTP valuation we can compare with a company’s market cap or perhaps its enterprise value.

This week I’m continuing with my ad hoc series on intrinsic valuation – estimating target prices for a stock, regardless of market pricing. I’ve previously visited this topic here, but in this piece I’m going to consider scenarios where I believe a sum-of-the-parts approach can be useful.

When is SOTP useful?

Choosing an appropriate valuation technique is an important element of developing meaningful valuation estimates. SOTP is appropriate in some situations and not in others.

For me, there are several scenarios where some kind of SOTP approach can be useful for stock-picking investors:

Liquidation: listed companies are sometimes shut down and sold off piecemeal. Untangling the balance sheet and cash flows to estimate a liquidation value can sometimes reveal shares trading at a discount to their fair value.

A timely example is the ongoing liquidation of a number of REITs and infrastructure investment trusts. While there are some troubled assets amongst these, my feeling is that some of these trusts are trading at unwarranted discounts to NAV. It might be profitable to buy their shares and gradually collect the proceeds as assets are sold.

Conglomerate discount: diversified groups controlling a number of unrelated businesses are less common than they were. But they still exist.

An ongoing example of a conglomerate that’s being split up is FTSE 100 industrial group Smiths, which recently pledged to narrow its focus and divest or demerge its other operations.

Irish group DCC – another FTSE 100 member – is another current example.

Spinning out divisions into separate businesses or trade sales can deliver attractive returns for shareholders, either through shares in the demerged business or through one-off capital returns. 

An example of this is agriculture and engineering mini-conglomerate Carr's (LON:CARR), which recently agreed the sale of its engineering division. This leaves it focused solely on livestock feed supplements.

Broker Cavendish referred to its SOTP valuation in its commentary on Carr’s break up:

The disposal proceeds confirm our SOTP-based target price of 180p, with the cash return of £70m representing about 74p per share, implying a c38p current value for the Agricultural operations, offering good upside.

Hidden value: we can sometimes find cases where businesses are trading significantly below demonstrable fair value, but management and (most) investors are seemingly unconcerned.

This hidden value is most likely to take the form of assets that aren’t earning a suitable return and could be more effectively employed or potentially sold.

This kind of situation is more often found at the smaller end of the market. For this reason, it pays to consider the management and ownership structure before deciding whether to invest.

UK small caps Camellia (see here) and Northamber (see here) are both notorious well-known examples. Value is hiding in plain sight at both firms, but may not be realised anytime soon. These value plays may be value traps.

Good businesses with a problem: in this final scenario, we have a relatively decent business whose overall results are being held back by the performance of a single unit within the group.

For a typical private investor with an interest in small and mid caps, I think this is probably one of the most common scenarios in which a SOTP approach may be helpful.

In the remainder of this article, I’m going to look at an example of how I might use SOTP techniques to help me decide whether to invest in a popular UK small cap, Zotefoams.

Is Zotefoams (LON:ZTF) undervalued?

Zotefoams counts Nike as its biggest customer and has valuable market share and intellectual property in this market, providing high performance foams used in sports shoes and a range of other applications. However, investors have fallen out of love with this specialist foams business over the last year:

Many investors were hoping to see the company take another big leap forward by commercialising a new product called ReZorce. This has the potential to be a more sustainable alternative to Tetra Pak type packaging used for food and drink (which is very hard to recycle).

Peak ReZorce fever coincided with a change of CEO, but the new boss has taken a more objective approach to investing in this opportunity. Having failed to find a suitable partner to support the development of ReZorce, Ronan Cox has put the project on ice and will not fund any further work.

For investors hoping for a transformative growth story, it’s a disappointment. But the reality is that the ReZorce activities were losing money and tying up assets in unproductive activity. Continuing to develop this project would have risked destroying shareholder value with no guarantee of success.

Happily, the company has given us an idea of the figures involved:

• Net asset value of MEL (ReZorce) business unit: £15.1m

• 2024 MEL segment operating loss of £4.7m

I’ve used these numbers to estimate the potential impact on Zotefoams’ profitability of discontinuing ReZorce development. The result is encouraging, in my view:

(I’ve estimated capital employed and net assets based on FY23 and H1 24 figures, assuming no significant change in H2 25 or FY25. This is only approximate, obviously, but hopefully illustrates the benefit of removing unproductive assets from a balance sheet.)

Zotefoams’ decision should have a favourable impact on profit margins, but also on the group’s return on capital employed and return on equity. This could be significant in terms of valuation.

The shares are currently trading just above their book value, perhaps reflecting the group’s historic sub-10% returns on equity.

However, it’s clear that the ReZorce division has been depressing Zotefoams’ overall profitability. Stripping out this loss-making division suggests to me that Zotefoams’ core business could be a higher quality operation than the market is currently recognising.

Of course, this is not a recommendation to buy shares in Zotefoams. There are still other factors to consider here. The outlook for 2025 appears to be fairly flat and Nike has seen its own growth slow recently.

Zotefoams needs to show that it can diversify away from its largest customer and win similar business elsewhere.

Even so, with Zotefoams shares trading at a post-2020 low, I think there’s probably more value on offer here than the market is currently recognising.

Disclosure: Roland owned shares in Unilever and DCC at the time of publication.