Investors should be wary of Valeant’s big ambitions

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You have to give Valeant Pharmaceuticals International Inc. credit for thinking big: It wants to become one of the world's five most valuable pharmaceutical companies by the end of 2016.

Let's put that into perspective. It implies that its market capitalization, or the value of all its shares, will more than triple to about $150-billion (U.S.) from $42-billion. And it assumes that the current fifth-largest company, Merck & Co., fails to budge over the next few years.

If it succeeds, Valeant would become the largest company on the Toronto Stock Exchange by far, given that the Royal Bank of Canada – which usually holds down the No. 1 spot – is worth a paltry $100-billion right now.

Audacious? You bet. But this sort of approach has worked well for Valeant in the past. Over the past five years, its stock has delivered a tenfold return after factoring in dividends, largely on an ambitious growth agenda.

Last year alone, it completed more than 25 acquisitions globally, highlighted by its $8.7-billion deal for contact lens maker Bausch + Lomb Holdings Inc. In a conference call with analysts, Valeant's chief executive officer said that it is pursuing more deals, and is also open to a merger of equals – which hints at something far larger.

In other words, another threefold return from the current share price doesn't sound too out-there.

Investors are certainly believers, driving up Valeant's share price by more than 12 per cent on Tuesday, to a record high.

Besides the promise of deals, there was other good news behind the rally. In its financial forecast for 2014, also released on Tuesday, Valeant said it would grow its adjusted earnings and revenue this year by about 40 per cent each – to as much as $8.75 a share and $8.6-billion, respectively. Both forecasts topped analysts' expectations.

However, as much as Valeant's share price has wowed investors in recent years, the stock doesn't stand out as a tempting opportunity going forward.

For one thing, there is a lot of good news already built in here. The shares have more than doubled over the past 12 months, to a level where the company's 2014 earnings projections are more or less assumed.

The shares trade for 15.4 times the company's own earnings estimates – roughly in line with Johnson & Johnson, but pricier than both Pfizer Inc. and Merck. Okay, there's no euphoria here, but the stock is no bargain either.

For another, the company's astounding growth through acquisitions has made it difficult to make clear judgments on its financial progress: Revenues are surging as more companies fall into its domain, but reported earnings can be lumpy if you ignore the so-called adjustments.

For example, Valeant reported a loss of $2.92 a share in the third quarter based on generally accepted accounting principles. The loss was largely the result of impairment charges and restructuring costs.

In contrast, the company's own calculation, in which it adjusts for what it regards as unusual items, shows it produced "cash earnings" of $1.43 a share.

There's nothing scandalous here, but investors who prefer to emphasize the company's numbers must assume the adjusted earnings will eventually fall into line with reported earnings.

And finally, there's the curse: The S&P/TSX composite index has a natural top-weighted company, Royal Bank of Canada, and any usurper to the throne suffers for its ambitions.

Over the past decade-or-so, stocks that have pushed aside RBC include Nortel Networks Inc., Barrick Gold Corp. and Potash Corp. of Saskatchewan Inc. – all super-hot stocks that subsequently turned stone-cold.

Do investors really want Valeant to aspire to such heights?

The pharmaceutical company has done very well picking off undervalued acquisitions in recent years, and is now among the top 15 drug companies in the world. The next step up is going to be far more challenging.