From the perspective of a potential equity investor, a key objective of financial analysis is to assess whether a company has the potential to produce price appreciation and dividend income in some combination that would provide an acceptable return to shareholders. These assessments typically view the company as a single entity and assume that it will continue to function as one; in other words, it looks at the company holistically, as a going concern. However, a company's value may also be seen as the value of its individual parts, where each part is assessed separately and the resultant values are added together. If the stock market is operating efficiently and all information is fully valued, a sum-of-its-parts assessment and a holistic, going-concern assessment (reflected in the stock's current trading price) should not differ materially from each other. However, in practice, this may not always be the case.
Potential reasons for inefficient assessments
Many factors could potentially distort a going-concern valuation. Among them are:
- The "conglomerate discount" Shares of companies whose primary business is divided among unrelated and disparate segments may trade for less in toto than if each of the segments were to be valued as discrete businesses.
- Limitations of historical cost accounting Certain assets (such as farm and forest land, for example) may be valued for accounting purposes at levels derived from their original purchase price. A company that has held significant assets valued at historical cost for long periods may find that some of those assets' current market values are substantially greater than their reported balance-sheet values.
- Business-segment specific difficulties Consolidation of financial information may obscure significant variation among different contributors to a business. Separation of a struggling segment could disproportionately boost performance of the remaining segments.
Publicly traded companies in the United States must disclose important performance information broken down by business segment and subsidiary. The most common potential primary sources of useful segment information are the annual report to shareholders and SEC Form 10-K, both of which are typically available from the investor relations section of a company's website. Independent stock analysts' reports may also provide information that is relevant for this kind of analysis.
Companies have substantial latitude in deciding how to structure their segment reporting. Some companies provide segment data in tables. Some provide it in their management discussion and analysis section, either as part of the overall narrative or in a call-out box. Still others put important segment data into the notes to their financial statements. Presentation formats can change from year to year. And sometimes an analyst must combine information from multiple sources within the reports in order to build a complete picture. Also keep in mind that you may not have precisely equivalent data for all parts of a company you want to evaluate, so you should be prepared to reach actionable conclusions with valuations derived from different methodologies—for example, discounted cash flow in one case, and earnings before interest and taxes in another.
There are at least two different approaches you can use for building a sum-of-the-parts analysis. The first is to go through all available sources and catalogue all of the information you have relating to segment or category breakdowns, whether it is lists of dollar values or of percentages. From that compilation, you can then determine what kind of values you can calculate about each and what additional information you might need to extrapolate effectively. The second approach is to look more narrowly at any particular business segment or subsidiary, and then seek all mentions of that particular entity. The first approach would lead you to all of the available comparisons, the second, to all of the incidental mentions of a particular point of interest.
Case study 1: A sample segment analysis
The General Motors Company designs, builds and sells passenger vehicles worldwide. According to its annual report, the company performed strongly overall, but a closer look suggested that there was significant variation from region to region. North America was strongly profitable and Asia, the Pacific Rim and Eastern Europe (collectively the GM International Operations segment) comfortable so. The primary European markets, however, generated significant operating losses.1
|Share of Company's Passenger Vehicle Sales, by $US-equivalent revenue||Share of Company's Passenger Vehicle Sales, by number of vehicles sold||Earnings before interest and taxes ($US Bn)|
|GM North America||59%||32%||$6,953|
|GM International Operations||17%||36%||$2,191|
|GM South America||11%||12%||$271|
Note than in the 2012 report to shareholders, this information was collected in a single table, but in the 2011 report, it was scattered about in the management discussion. Also keep in mind that these disparities by themselves may not signal any particular course of action, but they may simply reflect an object lesson in diversification, especially if changing economic fortunes alter the earnings distribution. Moreover, GM's product development and manufacturing are unified and globalized. The Buick Encore subcompact crossover, for example, is actually sold worldwide under several different GM nameplates. It was designed in Europe and is assembled in South Korea for the U.S. market, so only its final sales can be fully attributed by segment.
Case study 2: A sample asset analysis
Anadarko Petroleum is an oil and gas exploration company. Based on its mid-March 2014 stock price trading range the company could be valued at approximately $42 billion. A note in Anadarko's 10-K filing reveals that the company's proved petroleum reserves total some 2.8 billion barrels, which, if extracted and sold at the March 2014 market price of approximately $100 per barrel could gross $280 billion. But that would not completely reflect the costs of extraction over time, according to another note in the 10-K. Once drilling costs, royalties and contractual provisions were accounted for, the company says its proven reserves have a discounted net present value of $29.1 billion, which means proven reserves account for about 52% of Anadarko's total assets ($55.8 billion) and are the equivalent of about 69% of its total market capitalization.2
Segment and asset valuations offer important tools for understanding the valuation of a company under different scenarios and assumptions. These valuations can highlight potential sources of earnings and balance sheet volatility and suggest potential investment strategies.