Sign up UNITED KINGDOM
Proactive Investors - Run By Investors For Investors

Here’s how you should be valuing drug companies

Drug company valuations are largely made using a discounted cash flow model but it is far from a perfect system
pharma money, US dollars on pills
The model takes discounts the valuation based on which stage a drug candidate has reached

To properly understand any investment thesis in the drug discovery business, investors need to get to grips with discounted cash flow (or DCF) analysis.

As we’ve explained, much of the sector’s investor attention is focused on the process of taking drug candidates through the clinical trial process and, for those that are a success, through into the marketplace.

READ: Clinical trials are a high risk, high reward route to value creation

We know that as potential drug treatments ascend through the various trial phases they become more likely to reach the commercial stage – in other words, the potential value of the product is ‘de-risked’.

This is an important point to grasp because drug company valuations are largely made using a discounted cash flow model.

In the modelling approach, the stage of development is as a discounting factor.

The DCF data required for the spreadsheet are as follows:

An estimate of the numbers of patients annually likely to use the new, wonder drug

The price insurance companies and regulators will allow the company to charge for the product

The discount factors would be: the company’s expenses, likelihood of regulatory approval, the cost of capital and the time value of money

Case Study: Lungbuster

Here’s how Wizzo Capital’s analyst Dr Darren Dancer put together his DCF valuation of LungBuster (LB) for smokers’ cough (also known as COPD).

Finger in the air, he reckons LB could achieve peak sales of US$1.4bn if gets to the market.

The addressable market is big with 2% of the world’s population suffering COPD. In the US alone, there are 15mln people with the condition.

Using the US figure only, Dancer reckons the addressable market is US$6bn.

In year-one on the market, he expects LB to grab 1% market share, rising to 13% by year 10, giving sales of US$1.4bn.

He then ascribes a 9.6% probability of success and assumes any future royalty from sales will be 10%. On that basis, he reckons the future royalty from LB is worth US$20mln, or 17 cents a share.

The figure rises to US$55mln, or 45 cents a share following the completion of a pilot safety study in people with COPD.

It is worth pointing out LB has already successfully completed a safety study in patients with asthma.

Successful completion of a phase IIa study (which is slated to complete by early following) would catapult the drug’s net present value to US$140mln, or 90 cents a share.

The net present value (NPV) rises to US$376mln once a IIb study is successfully concluded.

Why DCF is an Inexact Science, or Possibly Even BS!

A familiar refrain of Proactive’s finance director when talking about our all-singing, all-dancing new accounting software is that the package is only as good as the data you plug in.

The same could be said of discounted flow analysis.

DCF is the default method of benchmarking research-stage life sciences companies because it provides a seductively simple method of valuing potential future revenues from drugs that have yet to find their way to market.

But to be truly effective it requires a fully functioning crystal ball.

Still, this doesn’t prevent City analysts inputting their estimates for the market size, market share and the potential price of the new pill or potion.

Even after discounting according to the stage of the research & development (R&D) cycle some truly eye-popping valuations emerge. But the DCF should be seen in the context of the information it omits as much as the data it includes.

What is meant by that?  For one, the forecast doesn’t always capture value triggers such as licensing deals.

Neither can it convey just how innovative the drug actually is, or whether after tens (or even hundreds) of millions of pounds invested whether insurance companies and health services around the world will pay for the new medication.

How can it account for deal-makers?

Expanding on the first point: very few small biotechs hit the home run of taking a drug from first principles all the way to the market.

Instead they rely on the deep pockets of big pharma that step in (usually once phase II trials are complete) to fund the remainder of the development.

A licensing deal with a larger firm is a value inflexion point for the smaller company (and its investors) as it will likely receive an upfront sum, further payments once certain milestones have been reached and a royalty on sales if the compound makes it to the commercial phase.

Often the staged cash instalments involved dwarf the market capitalisation of the minnow that first spawned the innovative drug picked up by the industry’s 600-pound gorilla.

Your DCF model, however elegant, won’t take into account whether a company’s management has a track record of tying up licensing deals with big pharma but it’s a filter worth applying.

Neither will it identify those businesses incapable of finding an industry partner that is happy to burn through shareholders’ cash.

Quality is also overlooked

Another factor overlooked is the quality of the product being developed.

Of course, the holy grail is the newly-discovered blockbuster with the capacity of generating peak sales in excess of US$1bn a year. But they are hard to find.

A fall-back might be to develop ‘me-too’ copies of the blockbusters, or ‘me-better’ products that have bells-and-whistle enhancements.

While arguably easier to create, they are entering crowded markets where there may a reluctance to switch from the brand leader.

The path to regulatory sign-off can be a little more fraught. ‘Me-toos’ and ‘me-betters’ tend to have to show better efficacy and safety than their forerunners to receive the regulatory seal of approval.

By contrast, if you have a genuinely innovative drug that tackles an area of unmet medical need then the regulatory pathway is shortened.

But even where there isn’t explicit guidance from the drugs watchdog, common sense and precedent suggest good innovative medicines are likely to find sign-off less taxing than a fifth or sixth me-too cholesterol drug.

View full PROIN profile View Profile

Proactive Insights Timeline

Related Articles

mobile phone
Tue
The marketing group has already said profits for the full-year will be ahead of expectations despite only being halfway through its current financial year
Throne of Glass
April 30 2018
Rowling, Rowling, Rowling ... keep those titles rolling. Mind you, it's not all about Ms Rowling; Sarah J Maas title revenues grew 47% in the first half of the financial year and dieters are gorging on Tom Kerridge's books
Media junkie
February 13 2018
In modern parlance, Ebiquity is making a pivot towards becoming the "world's leading tech-enabled marketing and media analytics consultancy"

No investment advice

The Company is a publisher. You understand and agree that no content published on the Site constitutes a recommendation that any particular security, portfolio of securities, transaction, or investment strategy is suitable or advisable for any specific person. You further understand that none of the information providers or their affiliates will advise you personally concerning the nature, potential, advisability, value or suitability of any particular security, portfolio of securities, transaction, investment strategy, or other matter.

You understand that the Site may contain opinions from time to time with regard to securities mentioned in other products, including company related products, and that those opinions may be different from those obtained by using another product related to the Company. You understand and agree that contributors may write about securities in which they or their firms have a position, and that they may trade such securities for their own account. In cases where the position is held at the time of publication and such position is known to the Company, appropriate disclosure is made. However, you understand and agree that at the time of any transaction that you make, one or more contributors may have a position in the securities written about. You understand that price and other data is supplied by sources believed to be reliable, that the calculations herein are made using such data, and that neither such data nor such calculations are guaranteed by these sources, the Company, the information providers or any other person or entity, and may not be complete or accurate.

From time to time, reference may be made in our marketing materials to prior articles and opinions we have published. These references may be selective, may reference only a portion of an article or recommendation, and are likely not to be current. As markets change continuously, previously published information and data may not be current and should not be relied upon.

© Proactive Investors 2018

Proactive Investors Limited, trading as “Proactiveinvestors United Kingdom”, is Authorised and regulated by the Financial Conduct Authority.
Registered in England with Company Registration number 05639690. Group VAT registration number 872070825 FCA Registration number 559082. You can contact us here.

Market Indices, Commodities and Regulatory News Headlines copyright © Morningstar. Data delayed 15 minutes unless otherwise indicated. Terms of use