In philosophy, “the whole is greater than the sum of its parts,” according to Aristotle. Mathematics tells us this cannot be true. But what about investing?
In investing, a common way to value a large conglomerate is to use a sum-of-the-parts analysis. Put simply, this method values each division then adds them up. It is often used to highlight hidden value in conglomerates; perhaps an asset or division whose full worth might not be appreciated by the market. But it can also be misleading as a tool for valuing companies.
Sum-of-the-parts analysis is often applied to value News Corporation (ASX:NWS). This is because it has dozens of well-known assets, including a 50% stake in Foxtel and a 61.6% stake in REA Group (ASX:REA), owner of realestate.com.au. Many analysts use it to determine their valuations, which tend to be well above the share price. The median of analysts’ share price targets is $22.66, which values News at $13 billion, some 30% above the $10 billion valuation implied by the current share price.
How do they derive such lofty valuations?
I am going to dramatically simplify this to make a point – the real world accounts are a tangle of consolidations and fiendish equity accounting – but assume News has three parts, REA, Foxtel and the rest (which is a mix of traditional media assets).
The market values REA at $8.6 billion, so News’ 61.6% share equates to $5.3 billion.
Foxtel has 2.9 million subscribers. If we value each subscriber at $1,500, in line with similar businesses listed elsewhere in the world, News’ 50% stake could be worth $2.2 billion.
Let’s value the rest of News at 11 times operating profit, which equates to $4.2 billion.
News also has a strong balance sheet with $1.3 billion of net cash. So the sum of the three parts and net cash is $13 billion. This represents a 30% premium to the current market value, precisely what the median analyst thinks it’s worth.
But precision is a term one should be wary of when describing sum-of-the-parts. Especially if one particular part is large, as it can distort the overall valuation. Most importantly for News, is the market value of REA an accurate reflection of its value?
REA is a large slice of the News valuation pie. Its current share price is at an all-time high of $65, which values the company at close to 40 times this year’s profit. Yet a year ago it was down at $39. If $39 is the right price, then News’ stake would be worth $2.1 billion less than it is today.
And while Foxtel is a valuable asset, penetrating 30% of households and recently offering broadband, its earnings are under pressure from the likes of Netflix. Since News owns a non-controlling stake, the accounting standards treat it as an affiliate. This means we get little transparency around Foxtel, just a profit number and not much else. As a result, it tends to have a much lower impact on earnings than it does on a sum-of-the-parts valuation. Over the last 12 months, it has contributed $50 million to profit (out of $447 million in total). One could feasibly value Foxtel at around half of the $2.2 billion we estimated above.
Using these less optimistic assumptions to value REA and Foxtel brings our valuation back to the current market value of $10 billion.
What else should investors be wary of when using a sum-of-the-parts? The simplest response to this question is to pose another question: if management has no intention of selling assets to realise value, then what’s the point of using a sum-of-the-parts?
In the case of News, there’s little track record of selling assets when the share price looks cheap. To management’s credit, their loss-making digital education business, Amplify, was sold late last year for an undisclosed sum. This business had lost over half a billion dollars in its three years under News ownership.
However, we are yet to see anything that would really give shareholders a reason to cheer. For example, News could distribute its REA shares to News shareholders and let them decide if they want to own it or not. This would be worth $9 a share, or just over half the current share price. Considering that REA comprises a quarter of News’ earnings, News shareholders would keep three quarters of the earnings but be paid for half of the company. This would certainly realise value.
What of News’ ability to create value through acquisitions? Could this justify the lofty valuation implied by the sum-of-the-parts? Unfortunately, News has a mixed track record on acquisitions. At one end of the spectrum, Amplify cost US $360 million and lost a lot of money. At the other end, News recently acquired APN’s regional newspapers for the cracking price of just two times EBITDA.
Somewhere in the middle, it paid US $950 million to acquire online real estate website Move. While Move is the third largest online real estate company in the US, its profits are small at present. It will be several years before we know whether News has bought a cracker or a lemon.
To sum it all up (pardon the pun), for companies run by management with a demonstrable track record of selling assets to unlock value, a sum-of-the-parts analysis may be an appropriate valuation tool. However, for management teams without such a track record, sum-of-the-parts analysis will tend to overstate the value of the company.
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Forager Funds is a boutique fund manager specialising in a value investing approach. We offer an ASX listed Australian Shares Fund as well as an International Shares Fund both aimed at delivering returns for long term investors.