Value A Biotech Company Against Risk – Seeking Alpha

Is there an easy way to assess the value of a biotech or pharmaceutical company based on its potential, cash, and asset position while adjusting for potential risk?

Are there any easy ways to enter an investment at a stage in which a company has passed a key FDA approval level for one of its drugs?

Biotech investors must recognize these issues. Weighing up the risk, and whether or not the company stock is over or undervalued, is a basic investment concern but one that can be hard to navigate in the Biotech industry. Various websites do provide information which makes the task easier, though.

Historical and Current Sector P/E

As reported in Forbes.com, biotech company values can achieve an extraordinary high P/E ratio when they're successful, and sentiment favors this sector. In 2015, on the most recent biotech stock 'highs', Zero Hedge reported that about 75% of biotech companies were not creating any profit despite high valuations. Perhaps this led many investors to assume the biotech industry was in a bubble. Investing in biotech isn't comparable with any other form of technology. Biotech companies acquire significant levels of venture capital to fund very long-term and extremely expensive new drugs and rely on high share price valuations to achieve this.

According to Investopedia:

Pharmaceutical stocks typically trade at a large discount to biotech stocks. The historical mean forward P/E multiple is 16x from 1976 through March 2013 for pharmaceuticals as compared to the high 20x to 30x or more for biotech.

Market Realist.com summarizes valuation factors:

A biotechnology company's (NASDAQ:IBB) value is comprised of two main factors: assets in place and growth assets. Assets in place, or drugs currently being sold in the market, are indicators of the present cash generation capacity of the biotechnology company. Growth assets involve drugs in a company's research and development (or R&D) pipeline as well as future licenses and collaborations with other pharmaceutical and biotechnology companies.

Many biotechnology companies carry substantial debt on their balance sheets. EV-to-EBITDA value can be used to determine the attractiveness of a mature biotechnology company. Low EV-to-EBITDA ratios may signal that the market is undervaluing the stock.

Since a large portion of a biotechnology company's value is derived from its R&D assets, discounted cash flow valuation (or DCF) proves to be a more effective valuation technique. However, this method is extremely sensitive to inputs related to future riskiness and returns of the company. So, wrong inputs can lead DCF in returning erroneous company values.

The problem is, of course, discounting for risk.

It can take 10 years or more to take basic experiments to a commercially viable product, and each stage requires extensive funding. There's a lot of risk involved, especially at the early stages, but investors in those companies which succeed are often generously rewarded. Weighing up risk is as crucial as buying at the right price; the two go together.

'Techinvest Daily' has a valuation suggestion. Here are some additional ideas, too, on where to source useful info, how to buy into a company which has just reached an FDA approval, reducing at least one level of risk.

FDA Approval Is A Lengthy, Costly, and Risky Business

Unlike P/E valuations (which are based on earnings, so exclude many small biotech companies) and 'DCF' (which is based on a cash flow measurement, a biotech valuation needs to account for reduced risk, as well as a product which is becoming increasingly viable as it successfully clears each of the three main hurdles needed for approval of each drug.

Assessing The Value Of The Pipeline and Third Party Resources

For example, a company has four products developing in its pipeline. We can assess a top value for each drug by multiplying its projected market share by its potential value, "assuming approval".

We can then risk adjust, the possibility of not passing regulations, by multiplying the value of each drug by the likelihood of its approval (the three hurdle assessment). This delivers a 'Risk Adjusted Value' or RAV which can be added together for the total company pipeline.

It would be difficult for investors to decide on the likelihood of approval in advance. There are websites which specialize in biotech company information like Biospace. The BioMedTracker Drug Intelligence Platform tracks company pipelines and drug catalysts, but otherwise, risk has to be assessed based on what's happened to other products trying to achieve similar results. Information is available from the FDA itself. Some sites which flag which products are waiting on approval include Biopharmcatalyst.com.

The Value of The Market Opportunity

Potential revenue numbers are usually provided by specialist biotech market intelligence companies, anticipating the potential for a company to acquire a share of a particular drug market. It doesn't account for potential profit. 30% of revenue or more can be lost to a drug distribution channel and profit influenced by costs like:

Other substantial costs can include sales and marketing (which can be significant to create national cover), as well as patent, office, and administration fees.

Risk Valuation Example

E.g. Company X

Maximum potential of $1 billion. RAV value, $500m (after adjusting for market share and the one-third level risk and likelihood of achieving that, the pipeline is worth $500m at the particular stage the products are at, plus cash, less debt).

Share value is (RAV + cash - debt/shares outstanding)

So, if company X were to have $50m in cash and $30m in debt, the calculation would look like:

$500m + $50m - $30m/50 million outstanding shares

or $520m/50 million shares means the stock is a good buy, trading under $10.20 relative to its risk.

Risk adjusted Value (RAV) = product valuation * market share * likelihood of approval

Risk Avoidance Measures

It's possible to avoid the individual company risk issues (while sacrificing some of the stock appreciation performance) by investing in one of the ETFs which track the biotech industry, like IBB. Service fees can accumulate for regular trading, though.

Armed with some specialist advise and having compared other companies developing similar products and their outcomes, an investor is able to make an improved risk judgement using the methods suggested. An investor can then decide whether buying into the stock is worth the risk involved in the pipeline. Further risk is reduced on buying a stock immediately following FDA approval of individual products, and potentially most advantageous following stage three approval.

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.

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Value A Biotech Company Against Risk - Seeking Alpha