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…
