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We have seen the foundations of corporate strategy.

Â Next, I'd like to discuss a tool that is commonly

Â used within corporate society, a sum-of-the-parts analysis.

Â This is a quantitative technique that people use to value multi-business firms.

Â Why is this technique important to you?

Â A sum-of-the-parts analysis can become a tool of power.

Â Have you ever been in a meeting?

Â That had a discussion of

Â a complicated spreadsheet that you didn't fully understand?

Â Now, what did you do in that situation?

Â If you're like many of us,

Â chances are that you didn't do anything.

Â You may have kept quiet and that is such a pity,

Â because not only is your opinion lost,

Â it might be that you are the expert in

Â the business or businesses that are being discussed.

Â Thus, I want you to be ready.

Â The goal is not for you to become an expert in this technique.

Â Rather, I want you to understand the method,

Â be able to do some of the basic calculations yourself,

Â and most importantly, participate in that discussion.

Â The way we are going to make progress is we start by valuing

Â a single business and then move to valuing multiple businesses.

Â We're going to value

Â a single business and let's say that business is a shipbuilding business.

Â As we're going to value business number four,

Â and the way we are going to do that is we're going to use

Â the information of other shipbuilding businesses,

Â number one, two, and three,

Â to come up with some data that we can use for our shipbuilding business, number four.

Â The second column that you see is enterprise value.

Â That basically means how much is the company worth.

Â If you were to buy that company or that business,

Â how much would you have to pay.

Â So, for business one that would be 120.

Â The third column is earnings,

Â which is what were the earnings in the last year.

Â And for this particular company,

Â number one, it was 20.

Â Given that we have information on enterprise value and on earnings,

Â we can calculate what is called a multiple.

Â In particular, we can calculate the multiple of enterprise value over earnings.

Â Let's do the calculation and then let's think about what it is.

Â It's a ratio, which means that we need to divide 120 by 20, which is six.

Â What does this multiple represent?

Â Well, it basically means,

Â if you want to buy business one,

Â you have to pay six times last year's earnings.

Â We can calculate the same multiple for the other businesses.

Â Even when the calculated multiple of our business two,

Â we do 70 divided by 10 equals seven.

Â Likewise, for business three,

Â we divide 120 by 15 equals 8.

Â Now, the next step is,

Â given these three multiples,

Â we're going to calculate the average across these three multiples.

Â And it turns out, the average of six, seven,

Â and eight is seven.

Â Now, we've come up with an average price for the other businesses.

Â Basically, we now know, on average,

Â a shipbuilding business is worth about seven times its last year's earnings.

Â In order to value shipbuilding business number four,

Â we're going to use that average and then calculate the enterprise value.

Â The next step for us is to use that average multiple.

Â We take this number and then do the opposite calculation.

Â We have the multiple,

Â we have the earnings,

Â so we should be able to calculate enterprise value.

Â And the way to do that is we're going to multiply the multiple times the earnings,

Â because then, earnings falls out and you're left with enterprise value.

Â So 15 times seven is 105.

Â Just to recap, we're using the average value of the other businesses,

Â one, two, and three, to calculate an enterprise value for number four.

Â We have more confidence in our valuation if businesses one,

Â two, and three, are more similar to business four.

Â We have less confidence in our valuation if businesses one,

Â two, and three, are more different than number four.

Â We've just valued a single business.

Â Now, let's move to the case of valuing a multi-business firm,

Â and let's say our multi-business firm has

Â three businesses: shipbuilding, homebuilding and trucking.

Â The basic idea is that what we did for shipbuilding,

Â that is comparing it with other shipbuilding businesses,

Â we're going to do exactly the same for homebuilding and for trucking.

Â For homebuilding, we will be comparing that business

Â with other homebuilding businesses and for trucking,

Â we will be comparing that with other trucking businesses.

Â So let's recap, in shipbuilding,

Â we had calculated a multiple of seven using the three other ship building businesses.

Â Now, using that multiple,

Â we could calculate a value for the shipbuilding business.

Â And the way we did that was we multiplied seven times 15,

Â giving us an enterprise value for just that shipbuilding business of 105.

Â Now, we're going to apply the exact same technique for homebuilding.

Â And let's say, our comparison with

Â other homebuilding businesses yielded an average multiple of 11.

Â And just to recap, that meant that on average,

Â the homebuilding businesses are worth roughly 11 times last year's earning.

Â If we multiply that multiple of 11,

Â times 10, we can derive the enterprise value for just homebuilding.

Â So, 10 times 11 is giving us 110.

Â As the next step,

Â we're going to replicate the exact same procedure for trucking.

Â We compare other trucking businesses and we find that their average multiple is eight.

Â Again, that means on average,

Â a trucking business is worth eight times last year's earnings.

Â So, if we multiply eight times 20,

Â we can infer the value of

Â our trucking business using the value of other trucking businesses.

Â Now, we've come up with a value for each business separately,

Â 105 for shipbuilding, 110 for homebuilding, 160 for trucking.

Â Now, we want to calculate the value of the entire multi-business firm.

Â There's only one step remaining,

Â and that is we need to include or incorporate headquarters.

Â There's basically two ways of doing that.

Â Either you can subtract the cost of headquarters

Â directly from the earnings of the individual businesses, that is,

Â you would allocate some cost to shipbuilding,

Â allocate some cost to homebuilding,

Â and allocate yet the remaining part to truckling,

Â which lead to lower earnings for each of these businesses,

Â or, you could do as is done here,

Â included at the very end.

Â Either way is fine, but what's important to remember is if you do it at the end,

Â we're talking about the ongoing cost of corporate headquarters.

Â It's not necessarily, or it's not last year's earnings only.

Â Now, we have all pieces in place and we can calculate

Â the enterprise value for our multi-business firm.

Â The way to do that is we're going to add everything in this column of

Â enterprise value and we need to keep into account that headquarters has a minus.

Â So, we subtract that from the whole.

Â If we add all these numbers 105, 110 and 160,

Â that gives us 365.

Â Now, based on our sum-of-the-parts analysis,

Â we've concluded that our multi-business firm is worth 365.

Â Actually, sum-of-the-parts are slightly more complicated, but not by a lot.

Â And in fact, the underlying logic is the same.

Â So, I hope you can now follow the sum-of-the-parts analysis.

Â Let's just recap what we have done.

Â For each business of the multi-business firm,

Â we're going to look for a group of focused peers,

Â that means a group of single business firms that are

Â comparable to the business that we want to value.

Â Using that group of focus peers,

Â we're going to calculate an average multiple.

Â We use that multiple of those other single business firms to

Â calculate the business or the value of our business.

Â And we're going to do that as often as the number of

Â businesses that we have in the multi-business firm.

Â Once we have valued each business of our multi-business firm,

Â we're going to add all values of these businesses,

Â which gives us a value for the multi-business firm.

Â The one thing that we need to keep in mind as a last step,

Â we need to include or subtract the cost of corporate headquarters.

Â We can either do that in step one or as the very last step,

Â as a step three.

Â This is the basic mechanism of a sum-of-the-parts analysis.

Â From the sum-of-the-parts analysis,

Â we concluded that the enterprise value was 365.

Â Now, we can think of that enterprise value consisting of two parts,

Â and those parts corresponds to the way a firm is typically financed,

Â debt and equity, or shareholders and bondholders.

Â One part of the firm or the enterprise belongs to the bondholders.

Â the other part belongs to the shareholders.

Â The part that belongs to the bondholders,

Â we refer to as debt or net debt.

Â The remaining part that belongs to the shareholders,

Â we refer to that as equity.

Â Now, we're interested in calculating the equity value.,

Â so if we know the enterprise value,

Â which is the total circle,

Â and you know the portion of net debt,

Â then we can subtract one from another,

Â giving us the equity value.

Â What we are going to do is we take the 365

Â minus the 165 giving us an equity value of 200.

Â Now, what we've done is we went from the value of

Â the entire enterprise to the value of the equity,

Â that is the value for the shareholders.

Â If we want to calculate the value per share,

Â all that we need to do is divide by the number of shares.

Â Here, the number of shares is very low, 20.

Â But imagine that this actually represent

Â 20 million and the equity value that we've been calculating is also in millions.

Â Then you can say, the equity value per share is simply

Â the equity value divided by the number of shares,

Â which is the 200 divided by the 20,

Â giving us an equity value per share of 10.

Â Now, this is how much we think the shares

Â should be worth based on our sum-of-the-parts analysis.

Â As the last step,

Â we can compare our calculations with how much this share is actually trading for.

Â In our sum-of-the-parts analysis,

Â we calculated an equity value per share of 10.

Â We can compare that number with the price for which the share is actually trading.

Â Let's say that share is trading currently at nine,

Â which means that our calculations are higher than the share price.

Â Those our sum-of-the-parts analysis,

Â yielded the price that was actually

Â higher than the price that the share is currently trading for.

Â And actually, that is a common finding

Â across many sum-of-the-parts analysis of multi-business firms.

Â Now, what does that mean?

Â Let's go to the next video to find out..

Â