U.S. stocks are lower in early-afternoon trading on Thursday, with the S&P 500 (SNPINDEX:^GSPC) and the Dow Jones Industrial Average (DJINDICES:^DJI) (DJINDICES: $INDU), down 0.21% and 0.29%, respectively, at 12:35 p.m. ET. Pundits are pointing to (among other things) the European Central Bank's decision to keep interest rates and stimulus programs unchanged and ECB president Mario Draghi's dour outlook for the eurozone.
This column has followed with fascination the Valeant Pharmaceuticals International Inc. (NYSE:BHC) debacle. While it has yet to fully play out, one can already begin to draw some preliminary lessons. That is what Professor Aswath Damodaran of New York University's Stern School of Business does at the end of his latest blog post, "Valeant: Information Vacuums, Management Credibility and Investment Value."
Yes, that title sounds a bit academic, but Prof. Damodaran writes in a clear and accessible style. I have written this before and I will repeat it: If you are a fundamentally oriented investor with an interest in stock-picking, his blog, Musings on Markets is a must-read.
First, if you're looking for the "actionable" conclusion, here it is: Damodaran, who valued Valeant at $72.10 per share last November, takes up the exercise again in light of the new information (and the missing information -- Valeant's much-anticipated 10-K) that has surfaced since then.
His new intrinsic value estimate is now $43.66 per share, 29% above yesterday's closing price of $33.53. That estimate reflects a number of adjustments to his assumptions, including a 5% probability of a forced liquidation of the company's assets and that half of all acquisition expenses will be shifted to operating expenses, reducing the operating margin by more than 3 percentage points.
(Damodaran's November valuation already assumed that Valeant's "innovative" business model, acquire/cut R&D/raise prices, was obsolete, so his adjustments were not that radical.)
On that basis, Damodaran bought the shares late last week at $32, with the caveat, stated in the accompanying video, that "this is one of those investments where I know bad things can happen."
(Need I add that investors should not simply go out and copy his actions? Stockpickers need to do their own due diligence.)
While it is educational to go through the details of Damodaran's valuation, I was more interested in the lessons he draws from the situation, among which the following resonated most strongly with me:
Companies that grow through acquisitions always make me nervous... Acquisition accounting creates a fog around the numbers, makes it more difficult to understand what a company has invested, how much it's investing, how well it's growing, how sensibly it's growing and what kind of margins it has – and those are all fundamental numbers to the valuation... Valeant reflects that problem in spades.
The golden metric
Cookbook corporate finance is not the answer: Each decade, consultants, investors, and companies seem to think that focusing on a key metric and looking good on it can be a substitute for good judgement and management. They are wrong.
Both of these combined into a highly combustible mix at Valeant. The company wanted analysts and investors to focus on adjusted EPS, adjusted EBITDA, and adjusted cash flow from operations, all of which are non-GAAP metrics (they do not conform to generally accepted accounting principles).
Just take a look at non-GAAP appendix in the fourth quarter (unaudited) results: Three full pages in small font of adjustments necessary to derive those metrics!
Still, they must have been useful and reliable since "[m]anagement uses these non-GAAP measures as key metrics in the evaluation of Company performance and the consolidated financial results and, in part, in the determination of cash bonuses for its executive officers."
Finally, Damodaran concludes with a thought that The Motley Fool believes is foundational: Valeant reflects the weakness of focusing on metrics rather than thinking about the business as a story with lots of moving pieces -- you cannot substitute a metric for good management. That's a powerful statement coming from someone who is an expert on valuation and spends a lot of time looking at the numbers.