Lesson 6 of 9
Sum of the parts
Value a multi-segment company piece by piece, on each segment's own multiple, then subtract the head office costs a simple sum leaves out.
By Javier Sanz
Founder of ValueScreener. Built Ninety Nine, a securities services provider, and sold it to a tier-one global bank; ran operations and internationalization at Alpaca, the brokerage API.
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In one minute
- A company of unlike businesses is valued piece by piece, each segment on the multiple its own industry trades at.
- The parts add to an enterprise value, where head-office costs, taxes and net debt still have to come out to reach equity.
- A simple sum without those subtractions overstates the business every time.
Some companies run businesses that do not belong on the same multiple: an industrial division, a software division, a stake in another listed company. Valuing the whole on one blended ratio hides that fact. Valuing each piece on its own market and adding them up does not.
From two segments and a stake to an equity value
- Segment A$600
- Segment B+$300
- Listed stake+$150
- Head-office costs, capitalised−$80
- Net debt−$200
- Equity value= $770
Read the segment note first
ASC 280 requires a public company to report the segments its own management reviews internally, each with its revenue and the profit measure management itself uses. That note, in Item 8 of the 10-K, is the starting point: it is the closest thing to an income statement for each piece, prepared by the people who run it rather than estimated by an outsider.
Value each piece on its own market
Value each segment the way the market values similar standalone companies. An industrial segment gets an industrial EV to EBITDA multiple. A software segment gets a software one. A listed stake already has a price.
Three subtractions a simple sum forgets
Head-office costs. Corporate costs that no segment carries, capitalised at the same multiple structure as the pieces they weigh on, come out of the sum. A holding company with no operations of its own still pays for a board, an audit, a head office. Leaving them out overstates the total by exactly their capitalised cost.
Net debt. The segments were valued on an enterprise basis, meaning before financing. Net debt bridges the enterprise value the parts produce to the equity value a shareholder actually owns, the same bridge used everywhere else enterprise value is compared with market capitalisation, and every other claim ahead of the shareholder: minority interests, preferred stock, pension deficits.
Tax on the stake. A listed stake is worth its market value less the tax due on its gain if it were sold. A sum that counts it gross overstates the equity by that tax.
Skip any one of these and the sum overstates the equity by the amount skipped, every time, because each is a real claim that a sum of operating pieces does not contain.
Where the method breaks
A shared cost that no segment's own multiple prices correctly, an intercompany transaction booked at a transfer price rather than a market one, or a segment definition that changed between filings, all move the sum without moving the business. The segment note is management's own view of its business. A company that reorganises its segments restates prior periods under the new lines, which can make a five-year segment series describe more than one internal structure.
The method also assumes a buyer for each piece exists at the multiple chosen. A segment too small, too regulated, or too tied to the parent's balance sheet to be sold on its own may never trade at the standalone multiple used to value it. That is one reason a sum of the parts can sit persistently above the company's own market price, without the gap ever closing.
Check yourself
Valued on their own EBITDA multiples, a company's two segments sum to 900. What two figures still come out before that is an equity value?
- Revenue and cost of goods sold
- Capitalised head-office costs and net debt
- Depreciation and amortisation
Show the answer
Answer: B.
The segments are valued on an enterprise basis. Head-office costs the segments do not carry, and net debt, both have to be subtracted to reach what a shareholder owns.Why value a listed stake at its quoted market value rather than on a multiple of its earnings?
- Because a stake never has reported earnings
- Because a traded price for that piece already exists
- Because multiples cannot be applied to minority stakes
Show the answer
Answer: B.
Where the market already prices a piece directly, using that price is more direct than reconstructing it from a multiple.Under ASC 280, whose view of the business does the segment note report?
- An independent auditor's
- Management's own internal reporting structure
- A standard industry classification
Show the answer
Answer: B.
Segments are defined the way management itself reviews the business internally, which is why a reorganisation changes the segment lines and restates the history behind them.Sources
- ASC 280, Segment Reporting, on the disclosures a public company makes about the segments management reviews internally.
- Klarman, Margin of Safety, 1991, chapter 8, on valuing a conglomerate's businesses by different methods and a portfolio of listed securities at its market value.
What this leaves out
- The worked example uses round invented figures so the arithmetic can be checked by hand.
- Segment operating profit is management's own allocation of shared costs and intercompany pricing, not an audited standalone income statement.
- ValueScreener reports EV to EBITDA at the company level, by sector, not segment by segment: applying a sector multiple to a segment is the reader's own step, not a stored figure.
- Nothing here is advice about any security.