Valeant's Earnings Don't Matter!

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U.S. stocks are higher on Tuesday, with the S&P 500 (^GSPC -0.22%) and the Dow Jones Industrial Average (^DJI 0.06%) (DJINDICES: $INDU) up 0.38% and 0.39%, respectively, at 2:45 p.m. EDT. Shares of Valeant Pharmaceuticals International (BHC -0.69%) are underperforming, down 14.40%.

Valeant's earnings don't matter

I was trying to come up with an expression that would be the opposite of "the gift that keeps on giving." The hand that keeps taking away, perhaps? Maybe it's easier and more evocative to just say "Valeant Pharmaceuticals."

On Tuesday, the embattled pharmaceuticals company lowered its full-year earnings guidance for the third time in six months. The adjustments were not trivial:

*Based on guidance range midpoints. Data source: Bloomberg.

Already punch-drunk from the repeated blunt force trauma of negative headlines (and the ensuing savage share price declines), investors were sent reeling by this new blow as the shares fell as much as 22%.

At this stage, it ought to be obvious that the adjusted earnings estimates Valeant provides are suspect (at best) or entirely meaningless -- either way, they are of little use to a fundamental investor. The same is true of historical earnings, incidentally.

(Unfortunately, the company was unable or unwilling to provide estimates based on generally accepted accounting principles (GAAP) today -- figures analysts said were necessary to determine whether Valeant will be able to produce adequate cashflows to service its whopping $31 billion of debt.)

Why do I say this? Because if adjusted earnings were a credible measure of Valeant's economic earnings power, the shares would not be trading at current levels. Consider that at $25, the stock is valued at less than four times this year's earnings-per-share forecast (based on the midpoint of the guidance range).

According to Bloomberg, Valeant's peer group of Global Specialty Pharma companies trade at a median multiple of 25 times estimated 2016 earnings per share.

There are two possible explanations for that discrepancy. The first is that the market believes Valeant's economic earnings are significantly lower than adjusted earnings estimates. The second is that the market believes Valeant faces a significant risk of financial distress. The stock's current valuation probably reflects some combination of the two.

(There is a third hypothetical explanation -- that Valeant is fairly valued and its peer group is hugely overvalued -- but I think it's sufficiently unlikely to reject out of hand.)

In theory, there is almost always a price at which you ought to be willing to buy a stock. With Valeant's shares having lost roughly 90% of their value from last year's high, some investors must surely be wondering if we have reached that point. However, given the risk of financial distress and/ or dilution, I think that's a question best left to speculators. Investors who are concerned with the safety of their principal ought to be put Valeant into the "too hard" pile: There are easier ways to earn a return in the stock market.

Quote of the day

With Apple, in his bullish days, [billionaire investor Carl] Icahn argued that it was cheap, but consider how he justified his contention in May 2015, that Apple, then trading at $100, should really be trading at $240. In effect, he forecast out earnings per share in 2016 to be $12, applied a PE ratio of 18 and added the cash balance of $24.44/share. Not only is this definitely not an intrinsic valuation, it is at best "casual pricing," i.e., the type of pricing you would do on the back of an envelope after you have had a little too much to drink.

-- New York University Finance professor Aswath Damodaran, Value and Price Effects of Big Name Investing