June 28, 2007

Valuing Biotechs

Valuing stocks can be a bit of an art and determining a value for biotech companies is even tougher, especially for biotechs without any products at market. So today I'll outline one of the methods I like to use when valuing companies. This method is called Risk-adjusted net present value, and it is fairly specific to the biotech industry.

Risk-adjusted net present value (rNPV) attempts to value a company by taking into account not only the future cash flows, but also the probabilities that those cash flows will even take place. This is especially useful for small biotechs that have not yet obtained FDA approval for a product. In using rNPV, we are able to find a company's value while taking into account significant events that could affect the stock price (like moving from Phase II to Phase III trials).

NPV is the same as a discounted cash flow analysis. It finds the present value of a firm's future cash flows. rNPV is similar. It is the present value of future cash flows, but those cash flows are adjusted by the probability of effect.
So, what are these cash flows? And, what are these probabilities?
These assumptions are crucial to our analysis of a small biotech.

1. Probabilities
Based on historical numbers, drugs in clinical trials have been approved by the FDA at the following rates:
Phase I: 20%
Phase II: 30%
Phase III: 67%
New Drug Application: 85%
(*These rates can differ +/- 5% based on differing types of drugs)
These percentages are the probabilities that we can use in finding rNPV. However, these percentages are the probabilities of a drug in each stage obtaining FDA approval. The percentage of drugs moving from one stage to another is the following:
Phase I to Phase II: 67%
Phase II to Phase III: 45%
Phase III to NDA: 79%
NDA to FDA Approval: 85%
These percentages are the probabilities that we use when a drug moves to a different stage.

2. Cash Flows
Determining a drug's cash flows can be very difficult. First, we must determine the costs. Secondly, we want to determine the potential revenues.

Costs tend to be determinate on the stage that a drug is in.
Phase I (1 year): $500,000 for animal testing + $12,000 per human subject (20-80 subjects)
Phase II (1.5 yrs): $1 mil for animals + $12,000 per human (100-300)
Phase III (3 yrs): $1.5 mil for animals + $6,000 per humna (1000-3000)
New Drug Application (1 yr): $1.8 million

A peak sales estimate (which can usually be obtained about 3 years after FDA approval) can be determined by taking the market size and multiplying it by an estimated market share. Also, drugs tend to have a life of around 10 years. Revenues are usually assumed to ramp up, and ramp down with about 5-7 years of peak sales.

Alright, let's make sense of this information.

As an example, let's take Fictional Biotech, Inc. FBI has a drug in Phase II trials. This drug treats pancreatic cancer, which has a market of $2.6 billion. FBI's drug has an estimated market share of 8%, which leads to potential peak sales of approximately $200 million.
Now, let's take a look at some cash flows. For example purpose, we'll look at years 1, 3, and 10

Year 1: Costs: -$1.7 mil for phase II testing
Year 3: Costs: -$6.5 mil for phase III testing
Year 10: Costs: 60% of Revenue, Revenues: $200 mil

So, according to the rNPV method, these cash flows must be adjusted by the probability that they will occur.

Year 1: rNPV Cash Flow = (Costs x Probability) = (-$1,700,000 x 100%) This stock is already in phase II, so the probability is 100%
Year 3: rNPV CF = (Costs x Probability that drug will move to phase III testing) =
(-$6,500,000 x 45%)
Year 7: rNPV CF = (Revenues x Cost of Revenue x Probability that drug will obtain approval)
($200,000,000 x 40% x 30%)

To conclude this quick intro to rNPV, to get a value for the company, we find the net present value of all the cash flows that each drug in the pipeline could bring in. We discount at the company's weighted-average cost of capital, which is usually 20% or more for a small biotech firm.

For more information on rNPV (and a better example) check out: http://www.maricopa.edu/bwd/pdfs/biotechpb.pdf

Also, Brian at Baby Biotechs outlines a similar formula here: http://www.babybiotechs.com/investment-strategy/investing-in-small-biotechs


HSA said...

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