Even pure-play companies often have a wide variety of underlying geographical and category segments.
If the economics of a company's segments are different, you will generate more insights by valuing each segment and adding them up to estimate the value of the entire company.
Trying to value the entire company as a single enterprise will not provide much insight, and the final valuation will likely be noisier than valuing by parts.
Valuing by parts generate better valuation estimates and deeper insights
Consider a single case where a faster-growing segment has lower returns on capital than a slower-growing segment.
If both segments maintain their ROIC, the corporate ROIC would decline as the weights of the different segments change.
Valuing by parts generate better valuation estimates and deeper insights into where and how the company is generating value.
That is why it is standard practice in industry-leading companies and among sophisticated investors.
Steps for valuing a company by its parts
Four critical steps for valuing a company by its parts are:
- understanding the mechanics of and insights from valuing a company by the sum of its parts,
- building financial statements by business unit - based on incomplete information, if necessary,
- estimating the weighted average cost of capital by business unit, and
- testing the value based on multiples of peers.
To value a company's individual business units, you need income statements, balance sheets, and cash flow statements.
Ideally, these financial statements should approximate what the business units would look like if they were stand-alone companies.
Creating financial statements for business units requires consideration of several issues, including
- allocating corporate overhead costs,
- dealing with inter-company transactions,
- understanding financial subsidiaries, and
- navigating incomplete public information.