Question on sum of the parts valuation

[terryli246]

Hi everyone,

I've got a question on using the sum of the parts valuation.  From the textbook, when we are using sum of the parts valuation, we sum up the valuation of different businesses for the company, and subtract the net debt.  The calculation makes sense to me when we are using DCF to come up with the valuation of different businesses, because the DCF results are the firm value, thus subtracting the debt is needed.  

However, It doesn't make sense to me why we still need to subtract the net debt when we are using P/E multiple instead of DCF to find out the valuation of different businesses.  Usually, when we are simply using the P/E multiple to calculate the target price for a company with single business, we don't have to subtract the net debt.  Therefore, how come when it comes to a conglomerate we need to handle the cash and debt even if we are using the simple P/E method?

Actually, I've seen someone just add the cash per share, instead of net debt per share.  So, it makes me quiet confused.  Could everyone help me out for the question?

[karlmarx]

Q1:

Your friend A wishes to sell you a business with earnings of $1 and book value of $10.

Your friend B wishes to sell you an identical business with earnings of $1, book value of $10, and debt of $10.

Assuming the two businesses are selling at the same price, which will you buy? Why?


Q2:

Your friend C wishes to sell you a business with earnings of $1 and book value of $10, of which $5 is cash.

Your friend B wishes to sell you an identical business with earnings of $1, book value of $20, of which $15 is cash.

Assuming the two businesses are selling at the same price, which will you buy? Why?


p.s. It is important to be mindful of the capital structure of the business when performing valuation using either p/e of dcf. Because both tools do not take it into account.

[weijian]

It depends on where the debt is nested. If at subsidiary level, it is non-course to parent (unless they made a corporate guarantee) and so does not need to be accounted for. If it is at parent level, then it should be accounted as indicated by Karlmax in the earlier reply.