There are only 3 questions that a prospective investor, regardless of industry or investment opportunity, needs to ask:
Why is the asset worth what it is worth today?
How will the asset be worth more in the future?
How will I realize a return on my investment?
These questions are merely the launch point for diligencing investment opportunities, but if you cannot provide simple answers then there is a layer of opacity that needs to be cut through.
When it comes to clinical-stage, pre-revenue biotech companies, the answers are not always so cut and dry.
In this short essay, we will provide you with a framework for considering the most pertinent questions that must be addressed to understand biotech investment strategy and feel confident in your ability to separate wheat from chaff. This framework is how MedicalGold selects the Featured Companies that we choose to diligence and present to our readers.
Let’s tackle the most difficult questions first: Why is the stock worth the market price and how will it appreciate over time the lifecycle of the drug development program (from preclinical research through FDA clinical trials and commercialization)? The answers lie in the wonderful world of valuations.
There are 3 main methodologies for valuing a pre-revenue enterprise or company whose value is predicated on an unproven but potential blockbuster technology. Unlike an operating company that is cash flow positive, clinical-stage biopharma companies are in the business of spending investor dollars to drive research and development, sometimes with no intention of actually taking the drug to market (in the case of a private transaction with Big Pharma). This prevents us from simply looking at a Price-to-Earnings or Price-to-Sales ratio to determine whether the enterprise is appropriately priced in the market. What we are going to have to perform requires a bit more nuance and some financial forecasting wizardry. Usually, a combination of methodologies is selected to increase confidence in the analysis. The particulars are highly dependent on the information that is on hand and how confidently we can project future revenue streams and account for risk.
The enterprise value of a company can be estimated by looking for comparable transactions in the same industry, of approximate relative size, and of equal value proposition. The assumption is that in an efficient, open market, one would expect that buyers would pay a reasonably similar amount as in precedent transactions. When it comes to valuing pharmaceutical companies, consideration must be made as to the unique nature of the transaction. Licensing deals must be compared to precedent licensing deals, etc. The precedent transaction must also consider the strength of the management team, working capital, access to infrastructure and outside expertise, etc. It is highly unlikely that a single precedent transaction (let alone multiple) was valued with these unique considerations in mind. When valuing a single pharmaceutical asset, the comparable transactions must not include a portfolio of pharmaceuticals. Identifying a single, standalone valuation is also highly unlikely. Thus, valuations of clinical-stage biopharma firms and single pharmaceutical assets based on this approach are crude and rife with error.
This approach involves summing the costs involved in production of the pharmaceutical (labor, materials, overhead, CROs, clinical R&D, regulatory approval). The costs must be extrapolated over the remaining economic life (REL) of the pharmaceutical asset, then discounted to the present value at the time of valuation. The major flaw in the cost-based approach is that cost does not equal value. Future economic potential of the asset drives pricing of the pharmaceutical. The cost-based approach is likely to undervalue the pharmaceutical asset and should only be seriously considered if a company is looking to liquidate its assets and commands no pricing power.
This approach involves the projection of income over the remaining economic life (REL) of the asset, discounted to the present value at the time of valuation, adjusted for the risk of failure at each successive phase of the FDA regulatory process, and with consideration given to the residual value after the asset sales have become obsolete. The remaining economic life of the asset is a critical factor in determine the valuation; pharmaceutical with a longer REL will be worth more than pharmaceutical with a shorter REL. Patent protection and orphan drug status have a significant impact on the REL – the economic life is dependent on the term of exclusivity for a proprietary drug. The discount rate used to calculate the net present value (NPV) also plays a significant role in valuation. Early-stage pharmaceuticals with unproven market power command a higher discount rate (20-30%) as investors demand higher returns for the heightened risk. When adjusted further for the risk of failure in the clinical trial process, the resultant formula represents a risk-adjusted net present value (rNPV). However, when an early-stage biotech company is the target of a proposed acquisition, it is more appropriate to use the weighted average cost of capital (WACC) of the acquiring company as the discount rate. For established pharmaceutical companies, a WACC of 10-15% is reasonable.
At MedicalGold, our preferred method of examining the stock prices of clinical-stage, pre-revenue enterprises is the Income approach.
This begins by constructing a risk-adjusted discounted cash flow model, which produces a risk-adjusted Net Present Value (rNPV) that we can use as a starting point for valuation. By no means does this approach alone capture the intangible value (and associated risk) of intangibles such as the strength of the management team. The devil is in the assumptions.
“All models are wrong, but some are useful”
- George E.P. Box
This quote captures the essence of financial forecasting. A model is only as good as its assumptions and our ability to predict them within a narrow margin of error.
Income-based Approach Assumptions
In constructing our risk-adjusted discounted cash flow model, we must consider the following variables:
- Discount rate
- Market capture, growth, and pricing
- COGS and SG&A once the drug asset(s) has gone to market
- Probability of clinical trial success
- Economic life of the drug asset(s)
The discount rate is an interest rate used to account for the time-value of money and the opportunity cost of making one investment over another. The riskier the investment, the higher the discount rate. This implies that investors need a higher rate of return to justify placing their cash in an uncertain asset. For a brand-new company that is spending the majority of their capital on research and development, the discount rate is used to adjust the forecasted future cash flows that could be generated once the drug product is commercialized. For businesses that are already revenue positive, the WACC can be used to see if a new drug development program (e.g., a novel cancer therapeutic for a specific type of cancer) is financially viable.
Market capture and pricing
This is a tricky one. It is good practice to create a range of scenarios to see just how sensitive the valuation is to the company’s success in marketing the new pharmaceutical (“sensitivity analysis”). Unsurprisingly, market capture and drug pricing are the most influential components of an income-based approach to valuation. If the drug candidate is going to solve a previously untreatable disease, then assume that the vast majority of the market will be acquired. If there are competing technologies, then it is wise to segment the market. For example, patients that do not respond to the standard of care represent an untapped pool of customers. Perhaps the drug candidate does not have to compete directly with other treatment options. Arthur Cook's method of estimating drug revenues is a well-delineated methodology, as described in his book Forecasting for the Pharmaceutical Industry (2015).
The actual cost of the approved drug will be a function of the company's required internal rate of return (IRR) and the new therapy's value-add over existing treatment options. The pricing will vary based upon who is actually paying for it - insurance, out-of-pocket patients, or Medicare. Controversy surrounding drug pricing models and pharmaceutical profits is nothing new, and both parties have attempted to curb biotech profits. Various strategies such as the "most-favored-nation" model (requiring drug developers to offer all countries the drug at the same price, capped by the cheapest list price), thresholds on pharmaceutical profits, expansion of Medicare's scope of covered drugs, and "march-in-rights" (read MedicalGold's editorial on the the Bayh Doles Act of 1980) have been proposed, but pushback from pharmaceutical lobbying groups has prevented significant change.
Cost of Goods Sold and Administrative Expenses
This is relatively easy. COGS and SG&A can be estimated as a percentage of revenue. I highly recommend The Pharmagellan Guide to Biotech Forecasting & Valuation (2016). According to a meta-analysis of 10-k filings from 35 small/mid-cap drug companies listed in the NASDAQ Biotechnology Index, median COGS and SG&A expenses were 15% and 34% of revenues, respectively. The cost of drug manufacturing is highly dependent on the type of drug (small molecule v. biologic), but costs continue to drop as manufacturing technology improves. Marketing expenses can be immense, especially for well-known pharma giants (Pfizer, J&J, etc), ranging from $10M to over $200M per year for a single drug.
Probability of clinical trial success
This is the boogeyman. Historically, 30% of trials fail in the preclinical/discovery stage, 40% fail in Phase 1, 64% fail in Phase 2, 37% fail in Phase 3, and 15% fail to get NDA approval by the FDA. Compound the probabilities… that’s less than a 1% approval rate of drugs that make it out of the lab. The outlook gets much better once a drug candidate completes the Phase 1 trial. A risk-adjusted NPV takes into account this risk of failure and adjusts the enterprise value by the compounded probabilities (depending on stage of development, of course). A more developed drug is a less risky drug and therefore a more valuable drug.
Economic life of the drug asset
This is an easy one. Patents and orphan drug status awards determine the period of exclusivity for a proprietary drug. It is important to look at the filing dates of the patents to make sure they are not set to expire when the drug is projected to complete clinical trials. Patents typically guarantee 15-20 years of protection from the date of grant. Innovators are constantly filing continuation patents to keep their intellectual property alive during the R&D process. Once exclusivity is lost and generics flood the market, you can expect the revenues to plummet. A terminal value can be assigned to capture the remaining value of the drug in perpetuity.
Your income-based valuation approach should result in an exponential valuation curve, as below (hypothetical numbers). It’s easy to see why clinical-stage biotech companies live and die by clinical trial results. A positive data set can equate to a doubling in valuation overnight. Below is a theoretical valuation curve for a pre-clinical stage biotech company valuated at $50M. This is a very common valuation for biotechs that have 2-3 lead drug candidates in their pipelines for cancer and infectious diseases.
Stay tuned for an example income-based valuation of one of our portfolio companies!