How Do Financial Analysts Implement the Sum-of-the-Parts (SOTP) Valuation Framework?

Posted: 30 Jun 2019 Last revised: 18 May 2020

See all articles by Grigoria Chlomou

Grigoria Chlomou

Athens University of Economics and Business - Department of Accounting and Finance

Efthimios Demirakos

Athens University of Economics and Business - Department of Accounting and Finance

Date Written: May 18, 2020

Abstract

In this study, we investigate how financial analysts implement the Sum-of-the-Parts (SOTP) valuation framework. Although SOTP constitutes a popular valuation approach among sophisticated practitioners and investors, it is mostly ignored by researchers and academics. We adopt a structured content analysis of 265 equity research reports written by 33 investment brokerage houses for 140 UK-based firms. We find that analysts typically use EBITDA multiples to implement SOTP. Furthermore, financial analysts are more likely to consider SOTP the dominant or preferred valuation model in their report. We show that managers disclose a greater quantity of segmental information if their firms are considered difficult to analyze and value by investors and creditors, thereby decreasing the information asymmetry with their capital providers. In specific circumstances, we document that financial analysts identify more segments in their SOTP analysis compared to the reportable segments in the firms' annual reports based on IFRS 8. We argue that the financial analysts' choice to employ a greater number of segments in their SOTP models might be primarily driven by their effort to support their reports' optimistic target prices. Finally, although SOTP seems theoretically ideal to estimate the value of a multi-segment firm, we do not find empirical evidence to support the hypothesis that SOTP significantly outperforms a full-blown Discounted Cash Flow (DCF) model, when the latter is used separately to value the company as a whole.

Keywords: Sum-of-the-Parts (SOTP), Valuation Models, Financial Analysts, Equity Research Reports, and IFRS 8

JEL Classification: G24, G32, M41

Suggested Citation

Chlomou, Grigoria and Demirakos, Efthimios, How Do Financial Analysts Implement the Sum-of-the-Parts (SOTP) Valuation Framework? (May 18, 2020). International Review of Financial Analysis, Forthcoming, Available at SSRN: https://ssrn.com/abstract=3411678

Grigoria Chlomou

Athens University of Economics and Business - Department of Accounting and Finance ( email )

76 Patission Street
GR-104 34 Athens
Greece

Efthimios Demirakos (Contact Author)

Athens University of Economics and Business - Department of Accounting and Finance ( email )

76 Patission Street
GR-104 34 Athens
Greece

HOME PAGE: http://www.aueb.gr/en/faculty_page/demirakos-efthimios

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