It’s a weird fact that the value of a car is actually less than the sum of its parts.
In other words, if you were to go to a car dealership, you would actually spend less on the car you drive away with than if you were to buy the individual parts from the manufacturer and assemble it myself.
Don’t believe me? Go to an autobody shop and ask how much a single panel costs then do the math yourself. Your car costs less if you drive it off the dealer’s lot (versus if you were to buy the parts individually and build the car yourself).
I use this example to illustrate something you notice in business valuations, equity investing, and even in real estate investing: We can place a value on something (a business, a stock, or a property) but that value is one number for the whole thing. There is also a “sum-of-its-parts” value as well.
Here’s a business example:
If I were looking to buy a business, I might identify the value of the business by looking at its balance sheet to examine its assets and liabilities, but I would also look at its cash flow and profitability to help me identify the business’ earning potential in the future.
But what if I wanted to buy the business but didn’t care about its earning potential in the future. Maybe I like the property it’s sitting on and the computer system they have and their list of customers. In that case, I might value the company different because I only care about the sum of its parts rather than the whole.
Here’s a stock market example:
If I were looking to buy a stock, I might value the stock by looking at the market capitalization (which is calculated by multiplying the outstanding shares by the stock price). This is the full value of the company if I were to ask every partial owner to sell me their shares right now.
But I might also consider the sum of the company’s parts by looking at the Enterprise Value (which is calculated as market capitalization plus debt plus minority interest and preferred shares minus cash). This takes into account not only the cost of buying every share but also the impact of other aspects of the company’s balance sheet.
(Note: There are other measures to value a company besides market cap and EV; I’m just presenting them here as two alternatives that each represent value in a different way).
Here’s a real estate example:
If I were looking to invest in a property, I might look at how much it cost to buy the property from the seller, which could be acquired via a real estate agent who gives me a “market comp” (which is an estimated selling price based on what similar houses have sold for recently).
But maybe I don’t want to buy the house because I want to fix up that house and rent it out. Maybe I love the property but think that I make more money in other ways – perhaps I can pull the brand new furnace out of the property to put into another property, and then I can turn around and sell the house without doing any more work on it because I know that a developer is going to pay top dollar for the land very shortly. So my value of the property is defined by its parts – the furnace and the land.
My point here is that I talk a lot about value but value is perceived in different ways. You might think of it as the difference between the value of the whole and the value of the sum of its parts (or, at least the value of the sum of its important parts). (I also wrote recently about value being the amount someone would pay and the amount of benefit it provided to them… but now I’m talking about two different kinds of value!)
Think of it like this. The value of the whole business (which I’ve represented in green) and the value of the sum of its parts (which I’ve represented in blue). In many cases, the value of the whole business is often more than the value of the sum of its parts.
But the graphic above doesn’t give the whole picture because those two values are never static. Each type of value rises and falls, sometimes together and sometimes independent of each other. There are times when the value of the whole is worth less than the value of the sum of the parts. It looks more like this…
WHY DOES THIS MATTER?
It matters because when we understand that there are two different values, we can make money.
As an entrepreneur, you might find businesses that you can buy at a lower price but whose sum-of-its-parts value is much higher. In this way, you can easily add assets (like equipment or a customer list) affordably. Take the example of a hair salon. If there is another hair salon nearby that is going out of business, you might be able to buy it quite cheaply, and easily make your money back by selling off the equipment, keeping the customer list for yourself, and by renting out the space to a different business.
As an equity investor, you might find undervalued stocks whose whole price is worth less than the sum of its parts. As the company improves and its stock price improves, your position improves. (This is a classic Warren Buffett play, by the way). If I were to give you an example, I’d suggest that Research In Motion fits the bill. The value of the company as a whole is very low (and getting battered down every single day) but there is a point at which the value of the company as a whole crosses under the value of the company’s sum-of-its-parts. In other words, someone could come in and buy the stock from its shareholders and then part out the company – selling its patents and its enterprise software and its customer database – and potentially make more than what they paid for all of its share prices. (Disclosure: I’m not sure what that price would be, but I suspect that we’re pretty close as of this writing!)
As a real estate investor, you might find a piece of land that you can buy and then subdivide into smaller lots to build and sell as a community. (In fact, you don’t even have to build the subdivision yourself; you just need to subdivide it and find a builder who will buy it from you and build). This is a very common way that real estate investors play the difference between whole value and sum-of-its-parts value.
Every business has a value as a whole and a value as the sum of its parts, and those two values move up and down. Scrappy capitalists are the ones who know those two values and pounce when the time is right.