Terms Of The Trade: The Sum-Of-Parts Stock Valuation Method

One of the common ways for analysts to determine the valuation of large conglomerates is to estimate a value for each different division within a company and then add up the values to get a total. This approach is called “sum-of-parts” valuation. A company’s sum-of-parts valuation is an approximation of what a company would be worth if it were broken up and each of its divisions were spun off.

There is no simple formula or equation for determining sum-of-parts valuation, because valuation methods differ depending on the industry or the division. However, generally speaking, the formula below is a typical approach.

Equity value = (value of segment A) + (value of segment B) + … + (value of segment N) – (net debt) – (nonoperating liabilities) + (nonoperating assets)

The more complex a conglomerate is, the more useful a sum-of-parts valuation can be. For example, General Electric Company GE has 10 different divisions in a number of different sectors: Capital, Power & Water, Energy Infrastructure, Healthcare, Corporate Items Eliminations, Appliances & Lighting, Transportation, Aviation, Energy and Oil & Gas. It’s difficult to value GE based on its overall numbers when it does so many different things.

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A GE sum-of-parts valuation would be extremely complex, so here’s a much simpler example. Wal-Mart Stores, Inc. WMT divides its business into three divisions: Wal-Mart Stores, Sam’s Club and International.

In Wal-Mart’s most recent annual report, the company disclosed the following sales figures for each of its segments:

• Wal-Mart Stores: $298.3 billion.
• Sam’s Club: $56.8 billion.
• International: $123.4 billion.

If you use price/sales ratio as the valuation metric of choice, you can assign different multiples to each segment and then add up the values of each.

Peers Costco Wholesale Corporation COST and Target Corporation TGT trade at an average price/sales of 0.56. If you choose to apply a 0.56 price/sales multiple to Wal-Mart Stores and a 0.40 price/sales multiple on the other two segments (due to weaker growth rates), you get the following valuations.

• Wal-Mart Stores: ~$54/share.
• Sam’s Club: ~$16/share.
• International: ~$7/share.

So, using this particular sum-of-parts method, you get a total value for Wal-Mart stock of $54 + $16 + $7 = $77/share.

This is just a very crude example, but if you were confident in your valuation method, that $77 would potentially be your price target for Wal-Mart.

When a company runs different divisions that focus on different businesses, applying the same valuation method for the entire company is not typically the best approach. Instead, consider using a sum-of-parts approach to assigning an appropriate value to each division of the company.

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