Using DCF In Biotech Valuation It can be tricky to put a price tag on biotechnology biotechnology co mpanies mpanies that offer little little more than the promise of success in the future. future. Just because so meone in the lab lab cries "Eureka!," "Eureka!," that do esn't necess arily arily mean that a cure has been fo und. und. In the biotech biotech secto r, it can take many years to determine whether all the effort will translate into returns for a company. However, while valuation may appear to be more guessw ork than science, there is is a generally generally accepted approach approach to valuin valuing g biotech biotech c ompanies that are years aw ay from payoff. In this article, we explain this valuation approach, which relies on discounted cash flow (DCF) analysis, and take you through the process step by step. SEE: Discounted Cash Flow Analysis Portfolio Valuation Approach Think of a biotech company as a collection of one or more experimental drugs, each representing a potential market opportunity. The idea is to treat each promising promis ing drug as a mini-company within a portfolio. Using DCF analysis, you can determine what someone would be willing to pay for that drug portfolio. In other wo rds, you determine the forecasted free cash flow of each drug to es tablish tablish its its se parate present value. value. Then, you add together the net present value of each drug, along with any cash in the bank, and come up with a fair value for what the whole company co mpany is worth today. today. A biotech biotech co mpany can have doz ens or even hundreds hundreds of drugs in in its developmental pipeline. However, that does not mean you should include them all in your valuation. Generally speaking, you should only include those drugs that are already in one of the three clinical trial stages. (For more information, visit the U.S. Food and Drug Administration's website.) As an investment, a drug that is in the discovery or pre-clinical stage is a very risky proposition, with less than a 1% chance of getting to market (according to an industry report published in 2003 by the Pharmaceutical Research and Manufacturers of America). Therefore, drugs in the pre-clinical stage are usually assigned zero value by public market investors. Forecasting Sales Revenue Forecast ing ing the sales revenue from each o f a biotech co mpany's drugs is is probably the most important important estimate yo u can make about future cash flows , but it can also be the mo st difficult. difficult. The The key is to determine determine what expected peak sa les wo uld uld be if - and this is a big "if" - a drug successfully makes it all the way through clinical trials. Normally, you will forecast sales for the first 10 years of the drug's life. SEE: Great Expectations: Forecas ting ting Sales Sales Gro wth
Market Potential You need to start by making assumptions abo ut the drug's market potential. Look at information provided by the company and market research reports to determine the size of the patient group that will use the drug. Analysts typically focus on market potential in the industrialized countries, where people will pay the market price for drugs. When making assumptions about a drug's po tential market penetration, yo u have to use yo ur ow n best judgment. If there is a competitive drug market, with limited advantage offered by the new drug in terms of increased effectiveness or reduced side effects, the drug will probably not win substantial market share in its product category. You may assume that it will capture 10% of that tota l market, or even less. On the other hand, if no o ther drug addresses the same needs, you might assume the drug will enjoy market penetration of 50% or more. Estimated Price Tag Once you have established a sales market s ize, you need to com e up with an estimated sales price. Of co urse, putting a price tag on a drug that addresses an unmet need will involve some guesswork. But for a drug that will compete with existing products, you should look at the price of the competition. For instance, pharmaceutical giant Roche's recently introduced HIV-inhibitor drug, Fuzeo n, costs just over $20 ,000 per year. Multiplying that price by the estimated number of patients gives you es timated annual peak sales. The biotech company won't necessarily receive all of this sales revenue. Many biotech firms - especially the smaller ones with little capital - do not have sales and marketing divisions capable of selling high volumes of drugs. They often license promising drugs to bigger pharmaceutical companies, which help pay for development and become responsible for making sales. In return, the biotech firm normally receives royalty on future sales. According to an article written by Medius Associates ("Royalty Rates: Current Issues and Trends," October 2001), the royalty rate for drugs currently in Phase I of clinical trials is normally a percentage in the single digits. As these firms move along the development pipeline, royalty rates get higher. In Figure 1, we break down an estimate of the peak annual sales revenues for a hypothetical biotech drug in a competitive market with a potential market size o f 1 million patients, an estimated sales price o f $20 ,000 per year and a royalty rate of 1 0%. Growth Stock Pick (CTLE)
Potential Market Size
1 million patients
Market Penetration Rate -Competition High 10% Estimated Market Size
100,000 patients
Sales Price
$20,000 per year
Peak Sales
$2 billion per year
Royalty Rate
10%
Peak Annual Sales Revenues
$200 million
Figure 1 - Calculating drug sales revenue
Drug patents usually last about 10 years. In our hypothetical example, we ass ume that fo r the first five years after com mercial launch, sales revenues from the drug will increase until they hit their peak. Thereafter, peak sales continue for the remaining life of the patent.
Figure 2 - Hypothetical estimate of s ales revenue for the chosen forecast period of 10 years
Estimating Costs When forecasting future cash flow s fo r a drug, you need to consider the cos ts o f discovery and bringing the drug to ma rket. For starters, there are operating costs asso ciated with the disco very phase, including efforts to discove r the drug's molecular basis, followed by lab and animal tests. Then there is the cost of running clinical trials. This includes the cost of manufacturing the drug, recruiting, treating and caring for the participants, and other administrative expenses. Expenses increase in each development phase. All the while, there is ongoing capital investment in items such as laboratory equipment and facilities. Taxation and working capital cos ts also need to be factored in. Investors sho uld expect o perating and capital costs to represent no less than 30% o f the drug's royalty-based sales. By deducting the drug's operating costs, taxes, net investment and working capital requirements from its sales revenues, you arrive at the a mount o f free cash flow generated by the drug if it becomes comm ercial. SEE: Free Cash Flow: Free, But Not Always Easy Accounting for Risk Our free cash flow forecast assumes that the drug makes it all the way through clinical trials and is approved by regulators. But we know this doesn't always happen. So, depending on the drug's stage of development, we must apply a probability factor to acco unt for its probability o f success . As the drug mo ves through the development process , the risk decreases w ith each major m ilestone. The Pharmaceutical Research and Manufacturers of America reported in 2003 that drugs entering Phase I clinical trials have a 15% probability of becoming a marketable product. For those in Phase II, the odds of success rise to 30%, and for Phase III, they climb to 60%. Once clinical trials are complete and the drug enters the final FDA approval phase, it has a 90% chance of success. These improvements in the odds of s uccess translate directly into sto ck value. By multiplying the drug's estimated free cash flow by the stage-appropriate probability of success, you get a forecast of free cash flow s that acco unts for development risk. The next step is to discount the drug's expected 10-year free cas h flow s to determine what they are w orth today. Because yo u have already factored in risk by applying the clinical trial probability of success, you do not need to include development risk in the disco unt rate. You can rely o n normal means o f calculating the discount rate, such as the we ighted average cos t o f capital (WACC)
approach, to come up with the drug's final discounted cash flow valuation. SEE: Investors Need A Good WACC What's the F irm Worth? Finally, you want to calculate the total value of the biotech firm. Once you have gone through all the steps outlined above to calculate the discounted cash flow for each of the biotech firm's drugs, you simply need to add them all up to get a total value for the firm's drug portfolio.
DCF Value Drug A + DCF Value Drug B + DCF Drug C … … = Total Firm Value The Bottom Line As you can see, valuing early-stage biotech companies is not entirely a black art. Intelligent investors can come up with solid stock valuation estimates if they are familiar with DCF analysis and are equipped with a basic understanding of the industry and how major developmental milestones can impact the value of a biotech firm.
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by Ben McClure Ben McClure is a long-time contributor to Investopedia.com. A specialist in preparing early stage technology ventures for investment and the marketplace, Ben manages the Business Incubator at the University of Malta. Ben was a highly-rated European equities analyst at London-based Old Mutual Securities, and led new venture development at TEC Edmonton, a major technology commercialization consulting group in Canada.
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