"Valeant's not going bankrupt…"
"Valeant will be bankrupt just like Sun Edison…"
"They will be able to pay the interest on their debts…"
"The stock will be 100 by the summer…"
"Avoid Valeant like the plague…"
These are just some paraphrased, random opinions you can find exploring the several articles on Valeant's (NYSE:VRX) current position.
How can we cut through the noise and get an unbiased picture of what's going on with Valeant? Have the financial statements been trying to tell us something?
There are several ratios at an investor's disposal to evaluate the financial position of a firm. Interest coverage ratio, current and quick ratios, debt to equity, etc. Looking at each ratio in isolation does not necessarily paint the full picture however.
Enter the Altman Z-Score
Combining several metrics into a statistical model to predict bankruptcy is exactly what E. I. Altman did in the late 1960s. He studied several firms that had become insolvent, and reviewed several fundamental ratios and tried to make sense of which were the key indicators of the firms fast approaching demise. He was specifically looking at
- solvency and
- activity of the firm.
Instead of evaluating different ratios in isolation, the model combines their effects into a single score, or the Altman Z-Score.
In statistical-speak, this is a "multivariate" model, as opposed to a "univariate" model.
To illustrate this concept, Altman provides an example:
"…a firm with a poor profitability and/or solvency record may be regarded as a potential bankrupt. However, because of its above average liquidity, the situation may not be considered serious." (page 4 of linked paper)
The original test was able to successfully detect bankruptcy (within 1 year) with a success rate of 95%. Detection 2 years in the future had a success rate of 72%.
You may be asking how an equation from the 1960s is relevant today.
Additional testing over periods 1969-1975, 1976-1995, and 1997-1999 detected firms approaching bankruptcy within 1 year, with success rates ranging between 82% and 94%.
If you are still not convinced, we'll take a look at a couple of recent cases where the Altman Z-Score would have predicted bankruptcy.
A quick look at the formula:
Z = 1.2(X1) + 1.4(X2) + 3.3(X3) + 0.6(X4) + 1.0(X5)
Altman proposed the following cut-off points:
Z > 2.99 - "Safe" Zone
1.8 < Z < 2.99 - "Grey" Zone
Z < 1.80 - "Distress" Zone
Each X factor is a fundamental ratio:
X1 = Working Capital/Total Assets
Measures the net liquid assets of the firm, relative to the total capitalization. Typically, consistent operating losses correspond to shrinking current assets to total assets.
X2 = Retained Earnings/Total Assets
Retained earnings (or earned surplus) is/are essentially the amount of earnings (or losses) reinvested back into the firm. A higher value suggests that assets have been financed more through cash flow generated by the firm, as opposed to debt financing.
X3 = Earnings Before Interest and Taxes (EBIT) /Total Assets
A variation of return on assets; the use of EBITDA instead of net income removes tax and/or leverage effects.
X4 = Market Value of Equity/Book Value of Total Liabilities
The measure shows how much the firm's assets can decline in value (measured by market value of equity plus debt) before the liabilities exceed the assets and the firm becomes insolvent. According to Altman this is a more reliable measure than the more familiar Net Worth/Total Debt (book values) metric.
X5 = Sales/Total Assets
Standard ratio demonstrating the firm's ability to utilize its assets. This value can vary widely between industries, depending on how assets are utilized (think of many capital light firms). Altman later proposed an alternative score for non-manufacturing firms.
Z'' Score - A Variation for Non-Manufacturing Firms
Due to the variations in X5 above (Sales/Total Assets) between firms, Altman proposed a variation of the formula for non-manufacturing firms:
Z" = 6.56 (X1)+ 3.26 (X2) + 6.72 (X3) + 1.05 (X4),
Where X1 thru X4 are the same as for the original Z-score.
Z'' > 2.60 - "Safe" Zone
1.1 < Z'' < 2.60 - "Grey" Zone
Z " < 1.1 - "Distress" Zone
(Altman also devised a score for Private firms, noted Z'.)
How does Valeant Measure Up?
Instead of jumping right in to see where Valeant stands in terms of a Z-score, let's see how the Altman score performed at predicting some recent bankruptcies.
Let's see what the Altman score predicted 2 years ago:
For both versions of the score (standard Z and non-manufacturer Z''), the Altman score would have given us a warning signal back in May of 2014 that SunEdison was in the distress zone.
Once again, results back in May of 2014 would have given a clear signal that something was amiss with RJET.
Finally, has the Z-score been trying to tell us something about Valeant?
In the best case (if considered a non-manufacturer, Z'' bottom chart), then Valeant has recently entered the distress zone.
Worst case, if one considers Valeant to be a manufacturer (Z, top chart) then it has been in the "distress" zone since the summer of 2015.
Like any statistical tool, there are margins of acceptable error with the Altman Z-score. I am not suggesting that the Altman score be a "silver bullet" in determining whether to hold on or sell short this stock. Like any tool in an investor's toolkit, this is a tool to help you leverage the unbiased value of the numbers, ask the right questions, and dig where you perhaps did not already.
It will be interesting to see how, if at all, the refiled 10K statements will change the Z score. I'm looking to follow up with an update on this score after the filing this Friday.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.