A long-time reader of my work at Morningstar and IOI, Wilson M., wrote in over the Thanksgiving holiday to ask me what option strategy would be appropriate for an investor wanting to act on a recent valuation of Valeant Pharmaceuticals (VRX) by Professor Aswath Damodaran, of New York University.
My first step in structuring an investment is to understand the valuation. When I started reading through Damodaran’s valuation notes, I was so surprised, I had to comment on some of the huge problems I see with his methodology.
Professor Damodaran is one of the world’s leading theorists on valuation and is regarded as a “valuation guru.” After reading through his valuation, honestly, I have a lot more sympathy for investors that are confused about what constitutes a good valuation.
In short, the problems I see are professor Damodaran’s:
- Use of point estimates of value
- Susceptibility to anchoring bias
- Reacting to Prospect Theory effects
- Failing to assess Valeant’s investment efficacy
Point Estimate of Value
Professor Damodaran reviews his previous valuations of Valeant – all of which are point estimates. As anyone who takes an IOI 102 course on valuation knows, estimating a company’s value using point estimates is fraught with practical and behavioral problems.
On the practical side, a point estimate represents the value of a company to a single number. Considering the complexity of a modern listed firm, we believe this simplification is unwarranted, unwise, and unhelpful to investors trying to get a realistic understanding of both risk and return.
On the behavioral side, valuing a company using a point estimate makes an investor susceptible to the powerful behavioral biases, including a very pervasive one known as “Anchoring.”
Anchoring
The first thing I noticed was that at least two of Professor Damodaran’s previous valuations were fairly close to the stock’s market price at the time: valuation of $77 / share when the stock was trading at $80 / share, $43.56 / share when the stock was trading in the mid-$30 / share range, and $32.50 / share when the stock was trading in the $17 / share range.
Professor Damodaran likes to talk about the “story” of a valuation.* The story that each of his valuations are telling are 1) “This stock is fairly valued” 2) “This stock is slightly undervalued but risky”, and 3) “This stock is a great investment idea.”
The second thing I noticed was that when he corrected his valuations, the corrections were very large. The drop from the original $77 valuation to the second $43.56 valuation (a curiously precise valuation, in my mind), implies a drop of more than two-fifths. The drop from the second valuation to the third is an additional 25% reduction.
Using IOI methods, valuations do not usually change so drastically, though different valuation scenarios can be very far apart. In an IOI context, perhaps each of professor Damodaran’s original point valuations would have been expressed as different IOI valuation scenarios. Since he invested in the stock at $27 / share and it is now trading at $15 or so, the recognition of multiple valuation scenarios might have saved the professor some psychological and financial pain.
Prospect Theory Effects
Notice that in each of professor Damodaran’s prior valuations, the potential return increases, as shown in the table below.
The Prospect Theory – a key finding by Tversky and Kahneman which we discuss in the IOI 101 class on Behavioral Biases – predicts that investors are willing to risk more as their losses increase and risk less when their gains increase.
There is a lot going on here, and I will not go into detail about it, but looking at the valuations above, I believe that after publicly announcing his prior valuations (thereby accepting the most drastic risk for financial professionals – career risk), professor Damodaran “doubled down” on his prior valuations in a way completely consistent with what Tversky and Kahneman predict with Prospect Theory.
Ignoring Investment Efficacy
Anyone who has taken the IOI 102 course on valuation or participated in any of our conference calls understands just how important an effect investment efficacy is to the value of a firm.
We look at investment efficacy from the standpoint of growth rates versus a standard yardstick (nominal GDP). Owners of a company whose management is investing well will see their firm’s profits grow much more quickly than the yardstick; owners of companies whose managers are investing poorly will see their firm’s profits lag behind the yardstick.
Valeant provides almost a perfect research subject since one of the main drivers of its revenue growth over time has been the acquisition of other companies. If Valeant’s managers were doing a good job of investing their owners’ profits, the revenue growth from these acquisitions would turn into sustained profit growth.
Here is a chart of our preferred measure of profitability – Owners’ Cash Profit (OCP) – for Valeant since 2008. How does the efficacy of the managers investments look to you?
Figure 1. OCP and OCP margin for Valeant. Source: YCharts
I have not looked any closer at the data, but like you, I can immediately tell that Valeant’s management has, in general, done a very poor job of investing its owners’ profits over this time period. There are a few bumps in profitability as new acquisitions are incorporated into the firm’s cash flow stream, but in general the trend is down. If compared to the growth in US GDP, certainly Valeant’s profit growth would lag even the tepid growth of the US economy since 2008.
What’s Valeant Worth?
I have never done a full valuation of Valeant and have only read the occasional article about the firm, so I can’t answer this question with any confidence.
The articles I have read, however, do cause me to be circumspect. At the end of the day, financial journalists (like all journalists) succeed professionally in direct proportion to the extent that their articles attract enough attention to sell advertising. As such, I am wary to accept their conclusions without a good bit of investigation on my own part, but my reading of these articles suggest that there is at least some chance that the company – heavily indebted and under increased regulatory scrutiny for shady business practices – will be forced to sell assets to stave off bankruptcy.
If this narrative has any truth to it at all, certainly one valuation scenario that cannot be ignored is the possibility that the company is worth nothing. Surely, professor Damodaran should at least address this possibility in his next valuation.
NOTES:
* The idea that an investor should create a “story” about a stock is actually one with which I strongly disagree. In my experience, creating stories about stocks actually hook into other behavioral biases and tend to prevent people from making objective valuations. My old portfolio manager told me once never to trust a salesperson with an English accent. The reason being that Americans are so taken by the posh accent and the lovely story-telling, that they fail to critically engage their brains when assessing the investment.