SOTP ( sum of the parts) valuation

[Arun Prakash]

Hi All,
I have a question on SOTP. Kindly help me out by sharing your view on the same.
In valuing an European Auto company I had to use SOTP since they operate 2 diff units - Industrial business (manufacturing unit) and Financial services.
Industrial business is valued using EV/Sales while the financial services is valued using P/BV. While doing this, should I use EV/Gross sales or EV/Net sales, meaning should sales be after or before elimination of intercompany transactions? In general, intercompany transactions are eliminated during consolidation but how are they treated in SOTP?
Note: Incorrect treatment can understate or overstate EV.

[Mani]

Hi AP,

Since the idea of SOTP itself is to arrive at the viability of individual business units treating it as a separate entity, any inter-company transaction (on an arms length basis) should be considered as a part of sales and valuation should be done at a gross level.

In your case, i assume that the financial services unit provides some services for which the IB unit is being charged. The P/BV ratio of the financial services company already captures the effect of inter company transactions in 2 ways :1. The reserves which is a part of book value includes accumulated funds on account of such transactions 2. The price already reflects the market's perception of future performance of that unit as a separate entity. For IB unit,impact on account of such transactions is captured in Enterprise Value. So valuing at gross level makes sense. Would like to know if there is a difference of opinion.

Thanks

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[Sathyamurthy U]

Arun and Mani,

I feel you should look at net sales than gross sales for the following reasons -

 

1.  Consider a company that manufactures laptops and loads a software developed by them into it and sells it.  It you want to do a SOTP of laptop manufacturing division and software services division, it is appropriate to consider net sales of laptop manufacturing division because the value created in manufacturing the laptop is factored in the sales of laptop bundled with software in the other division.  If you consider the gross sales then you are double counting.

 

Please let me know your views.

 

Regards,

Sathya

[Mani]

Hi Satya,

Considering transactions on an arms-length basis, the consideration paid for that software shall reflect as a part of expense for the manufacturing division(against the value created on account of the same) and as a part of revenue for the software division. So double counting is avoided. Morever, when using EV and market price of individual units for valuation, removing the effect of intercompany transactions from the market's perception would be difficult when net sales is considered. Any views ?

Thanks

[Abhishek Roy]

When you consider gross sales its more of consolidation than sum of parts. when one is valuing each division separately, it has to to be the gross sales as  you are looking at the business division as a separate business entity. 

[Sathyamurthy U]

Mani,

 

Three points -

 

1. Whatever basis the transaction may be (arms length or a under cut deal) taking into consideration the gross sales figure for 2 divisions which are transacting with each other amounts to double counting the value created in initial part of the value chain (Manufacturing laptop)  with the software division.

 

2. Another example  - iron ore is converted into sponge iron and then into steel billets.  If I want to value the sponge iron division and billet division seperately i would only take into consideration the sponge iron sold externally because I cannot find out at what cost the billet division is buying the sponge iron from (its internal division). So the value created out of the sponge iron manufacture is accounted for while valuing the steel billet division and is not counted twice, once while valuing the sponge iron and steel.  IF i have eliminate the value of sponge iron sourced from the internal division, I would need to know at what cost steel div is buying sponge which is not disclosed.

 

 

 

3. Net sales  = Gross sales - Excise duty - intersegment sales/inter division transfer.

Regards,

Sathya

[Mani]

Double counting can happen if the objective is to arrive at the gross sales at consolidated level.But here  the objective is to find out the value of individual units as a separate entity and add it. Here we are using two ratios EV/Sales and P/BV. I think Arun is concerned about the sales figure for the IB unit. Yes you are right when u say that the value addition of the Fin services unit is captured in the Gross sales. 
But against this value addition the IB unit must have paid some service charges to FS unit, which will reflect in their its bottom line viz.  its value addition. Future prospects of this value addition is reflected in the market price and hence EV. Investopedia says "EV/sales gives investors an idea of how much it costs to buy the company's sales". This ratio is used here because automobile industry is a cyclical industry and it wud be better for an investor to know how much they are paying for a dollar of the company's sales rather than a dollar of its earnings as in P/E ratio. This facilitates comparison with their peers in the industry. These peers might outsource certain components, services or keep some in their umbrella itself. So for a better comparison and hence valuation, Gross Sales gives you the correct picture than net sales. Cant think of a better explanation.

For FS unit, sales is not a concern. Since P/BV ratio is used, i assume it is a listed company so its value addition is reflected both in  price and book value.

Note : Eventhough debt is factored in EV/Sales, i feel it doesnt give a good picture  coz the value addition is not reflected properly unlike PE ratio.

[Arun Prakash Selvaraj]

Hi Mani and Sathya,

Thanks for your insights. I am inclined to agree with Nagamanikandan on this. IB unit usually has cash more than the gross debt resulting in Net cash position. On the contrary, FS unit has more debt compared to cash. This is mainly due to IB units selling its automotives to FS. Hence if we were to deduct this intercompany sales/transaction, the EV calculation would be flawed. As mentioned below, any transaction within units is paid for and is captured in equity. However I am having difficulties proving the same using an illustration. Any calculation that prove or disprove my point is welcome. Numbers speak louder than words :-)

P.S. EV/EBITDA can be reconciled to PE. Consistent application of long term assumptions will result in same values under both relative valuation methods and absolute valuation methods. I have done many such reconciliations proving this. Let's save the discussion for another day :-)

Best Regards,

Arun Prakash.S