0:09

We have seen the foundations of corporate strategy.

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

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

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

Why is this technique important to you?

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

Have you ever been in a meeting?

That had a discussion of

a complicated spreadsheet that you didn't fully understand?

Now, what did you do in that situation?

If you're like many of us,

chances are that you didn't do anything.

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

because not only is your opinion lost,

it might be that you are the expert in

the business or businesses that are being discussed.

Thus, I want you to be ready.

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

Rather, I want you to understand the method,

be able to do some of the basic calculations yourself,

and most importantly, participate in that discussion.

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

a single business and then move to valuing multiple businesses.

We're going to value

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

As we're going to value business number four,

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

the information of other shipbuilding businesses,

number one, two, and three,

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

The second column that you see is enterprise value.

That basically means how much is the company worth.

If you were to buy that company or that business,

how much would you have to pay.

So, for business one that would be 120.

The third column is earnings,

which is what were the earnings in the last year.

And for this particular company,

number one, it was 20.

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

we can calculate what is called a multiple.

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

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

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

What does this multiple represent?

Well, it basically means,

if you want to buy business one,

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

We can calculate the same multiple for the other businesses.

Even when the calculated multiple of our business two,

we do 70 divided by 10 equals seven.

Likewise, for business three,

we divide 120 by 15 equals 8.

Now, the next step is,

given these three multiples,

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

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

and eight is seven.

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

Basically, we now know, on average,

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

In order to value shipbuilding business number four,

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

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

We take this number and then do the opposite calculation.

We have the multiple,

we have the earnings,

so we should be able to calculate enterprise value.

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

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

So 15 times seven is 105.

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

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

We have more confidence in our valuation if businesses one,

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

We have less confidence in our valuation if businesses one,

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

We've just valued a single business.

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

and let's say our multi-business firm has

three businesses: shipbuilding, homebuilding and trucking.

The basic idea is that what we did for shipbuilding,

that is comparing it with other shipbuilding businesses,

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

For homebuilding, we will be comparing that business

with other homebuilding businesses and for trucking,

we will be comparing that with other trucking businesses.

So let's recap, in shipbuilding,

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

Now, using that multiple,

we could calculate a value for the shipbuilding business.

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

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

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

And let's say, our comparison with

other homebuilding businesses yielded an average multiple of 11.

And just to recap, that meant that on average,

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

If we multiply that multiple of 11,

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

So, 10 times 11 is giving us 110.

As the next step,

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

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

Again, that means on average,

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

So, if we multiply eight times 20,

we can infer the value of

our trucking business using the value of other trucking businesses.

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

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

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

There's only one step remaining,

and that is we need to include or incorporate headquarters.

There's basically two ways of doing that.

Either you can subtract the cost of headquarters

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

you would allocate some cost to shipbuilding,

allocate some cost to homebuilding,

and allocate yet the remaining part to truckling,

which lead to lower earnings for each of these businesses,

or, you could do as is done here,

included at the very end.

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

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

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

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

the enterprise value for our multi-business firm.

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

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

So, we subtract that from the whole.

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

that gives us 365.

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

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

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

And in fact, the underlying logic is the same.

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

Let's just recap what we have done.

For each business of the multi-business firm,

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

that means a group of single business firms that are

comparable to the business that we want to value.

Using that group of focus peers,

we're going to calculate an average multiple.

We use that multiple of those other single business firms to

calculate the business or the value of our business.

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

businesses that we have in the multi-business firm.

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

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

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

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

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

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

as a step three.

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

From the sum-of-the-parts analysis,

we concluded that the enterprise value was 365.

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

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

debt and equity, or shareholders and bondholders.

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

the other part belongs to the shareholders.

The part that belongs to the bondholders,

we refer to as debt or net debt.

The remaining part that belongs to the shareholders,

we refer to that as equity.

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

so if we know the enterprise value,

which is the total circle,

and you know the portion of net debt,

then we can subtract one from another,

giving us the equity value.

What we are going to do is we take the 365

minus the 165 giving us an equity value of 200.

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

the entire enterprise to the value of the equity,

that is the value for the shareholders.

If we want to calculate the value per share,

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

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

But imagine that this actually represent

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

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

the equity value divided by the number of shares,

which is the 200 divided by the 20,

giving us an equity value per share of 10.

Now, this is how much we think the shares

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

As the last step,

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

In our sum-of-the-parts analysis,

we calculated an equity value per share of 10.

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

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

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

Those our sum-of-the-parts analysis,

yielded the price that was actually

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

And actually, that is a common finding

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

Now, what does that mean?

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