You enjoy following spinoff stocks and a telecommunications firm announced a pending spinoff. It sounds good but is it a good investment? To find out you’ve got to answer the value question… How do you value a stock spinoff?  

How Do You Value a Stock Spinoff?

To value a stock spinoff you analyze the firm’s financial statements, potential undervaluation, growth probability, and industry peer comparisons. Here’s your analytic framework:

Financial Statement Analysis – Financial statement analysis highlights the spinoffs fiscal performance. Areas of interest are revenue, net income, free and levered cash flows, and debt. Assessing gross and net margins, return on equity (ROE) and return on invested capital (ROIC) will show profit trends.

Discount Cash Flow Model (DCF) – How do you value a stock spinoff? Here’s a valuation staple. The DCF is used as an indicator of an undervalued company. The model considers all spinoff cash flows in perpetuity and discounts them back to present value. The discount rate is the investor’s required rate of return, or the cost of capital can be used.

This value is the stock’s intrinsic value and when it is higher than the current share price, the shares are trading at a discount, therefore, are undervalued. The spinoff must be undervalued to be considered for investment.

Management Guidance and Trends – Read management’s assessment of the spinoff’s operational focus, growth potential, and foreseeable risks. Familiarize yourself with the micro and macroeconomic paradigms that impact the new entity’s valuation.

Company Comparable Assessment – Compare the soon-to-be publicly traded spinoff with like-companies in the industry. Assess the spinoff financial metrics (revenue and net income growth, gross and net margins, debt-to-equity, ROE, and ROIC) with industry peers. Determine the spinoff initial market position and comparable financial strength.

How Do Spinoffs Affect Stock Price?

A spinoff can positively affect the stock of the parent company and its own, here’s how:

Parent Company Stock Price – The parent stock price may initially decline because investors, due to their assessment of the parent firm’s uncertain future, sell pre-spinoff shares. Long-term, the shares may rise because a more streamlined business model allows for an efficient core business concentration.

Spinoff Stock Price – Short-term volatility is a common occurrence for newly traded spinoff shares. Given time, the post-spinoff shares may experience price appreciation. The independent firm now has a dedicated focus on its core operations, attracting new investors, which influences growth prospects, fiscal performance and may generate positive market sentiment.

How do you value a stock spinoff? Objective valuation is the needed foundation to answer our next question.

Do Spinoffs Create Shareholder Value?

Yes, spinoffs can create shareholder value provided specific conditions exist and they are:

Core Business Focus – Spinoffs must concentrate on their core competencies leading to operational efficiency and improved long-term growth performance.

Unleashed Hidden Value – Spinoffs emerging from the parent company’s shadow gain a clearer understanding of its independent value. The opportunity to chart its own financial course carries a certain amount appreciating equity value.

Capital Allocation – More efficient capital allocation is a positive externality that drives long-term shareholder value. Strategic growth initiatives tailor-made for the spinoff and dedicated capital deployment are a profitable duopoly.

Tax Efficiency – Spinoff tax treatment is jurisdiction-dependent. The spinoff transaction has tax advantages for the parent firm’s shareholders and can extend to new spinoff shareholders under certain holding conditions, as well.

How do you value a stock spinoff? You value a stock spinoff by conducting an organized, objective analysis of the financial facts, growth prospects, and peer comparisons. Accurately assess the historic and present data and let reversion to the mean do the rest.

Read next: What is the Difference between a Spin Off and a Spin Out?

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