An approach to valuing a company in which each business unit / operation is valued based on either discounted free cash flows (DCF) or peer multiples. The sum of these parts makes up the total enterprise value (EV) of the company (value of operations).

SOTP is regarded as the best tool to value companies with diversified business interests. It evaluates each business or division of the company separately and assigns a value to its contribution. This valuation also captures future potential of the new ventures which are not generating revenues right now. At the end, the values of all the parts (including core business) are added up to arrive at an approximate value of the company as a whole. SOTP valuation indicates if the company’s value would be increased if it was split into separate business units.

Consider a company that has three business divisions – a power generation plant, a sugar manufacturing business and a confectionery business. The approach that we take here is that we treat each of these businesses as a different strategic business unit (SBU) having its own Balance Sheet and P&L. In turn we assume that each of these businesses has a different risk, sources and uses of funds, different RoEs and different growth rates which is a fairly logical thing to do considering the nature of three businesses. We then use either DCF or price multiples to come up with value of each business and thus come up with the EV and subsequently value of equity of the firm.

Relative Valuation

In relative valuation, the value of an asset is compared to the values assessed by the market for similar or comparable assets. To do relative valuation then

• we need to identify comparable assets and obtain market values for these assets.

• convert these market values into standardized values, since the absolute prices cannot be compared This process of standardizing creates price multiples.

• compare the standardized value or multiple for the asset being analyzed to the standardized values for comparable asset, controlling for any differences between the firms that might affect the multiple, to judge whether the asset is under or overvalued.

Most valuations in the markets are relative valuations

• Almost 85% of equity research reports are based upon a multiple and comparables.

• More than 50% of all acquisition valuations are based upon multiples

• Rules of thumb based on multiples are not only common but are often the basis for final valuation judgments.

While there are more discounted cashflow valuations in consulting and corporate finance, they are often relative valuations masquerading as discounted cash flow valuations.

• The objective in many discounted cashflow valuations is to back into a number that has been obtained by using a multiple.

• The terminal value in a significant number of discounted cashflow valuations is estimated using a multiple.

Relative valuation is much more likely to reflect market perceptions and moods than discounted cash flow valuation. This can be an advantage when it is important that the price reflect these perceptions as is the case when,

o the objective is to sell a security at that price today (as in the case of an IPO)

o investing on “momentum” based strategies

With relative valuation, there will always be a significant proportion of securities that are undervalued and overvalued. Since portfolio managers are judged based upon how they perform on a relative basis (to the market and other money managers), relative valuation is more tailored to their needs. Relative valuation generally requires less information than discounted cash flow valuation (especially when multiples are used as screens).

Even if you are a true believer in discounted cashflow valuation, presenting your findings on a relative valuation basis will make it more likely that your findings/recommendations will reach a receptive audience. In some cases, relative valuation can help find weak spots in discounted cash flow valuations and fix them. The problem with multiples is not in their use but in their abuse. If we can find ways to frame multiples right, we should be able to use them better.