DNA makes RNA makes Protein makes Money...

The surge in start-up ventures and academics setting up shop in the hopes of bringing the the latest in biotechnology to the consumer, presents investors with a major problem. One that has its fundamentals embedded in traditional number-crunching, and yet is so subject to external variables that it seems to involve more guesswork than science. The problem I refer to is that of "Valuation". How does one find that hidden gem amidst the slew of companies promising future success? How do you value a company that has no track record, no revenue and almost no assets? If Steve Jurvetson Managing Partner at Drapper/Fisher/Jurtvenson were here, his response would be - "in a very subjective & capricious way".

Valuation can take on many forms. However, When performing a valuation, you will find there are three well known approaches : DCF or income approach, market approach, & the asset approach. The generally accepted approach to valuing healthcare companies that are years away from payoff uses Discounted Cash Flow (DCF) which tries to work out the value of a company today, based on projections of how much money it's going to make in the future.


DCF analysis says that a company is worth all of the cash that it could make available to investors in the future. The major difference in using DCF in valuing healthcare companies versus other sectors is the flexibility to take a product-centric approach. What this means, is that you must be willing to treat each potential drug as a separate entity within a portfolio. Hence, in order to obtain an amount representing the fair value of the entire company today you must:

• Determine Free Cash Flow (FCF) of each drug
• Adjust FCF to Risk
• Determine a Discount Rate
• Determine DCF (which is Risk adjusted FCF x Discount)
• Obtain Total Enterprise Value

It is generally safe to say that it is only worthwhile conducting a DCF analysis on drugs that are in the clinical trial stage. 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). So, drugs in the pre-clinical stage are usually assigned zero value by public market investors.

Determining FCF requires the Peak Annual Sales Revenue and an estimation of costs. Forecasting sales revenue for each drug is probably the most important estimate that needs to be made. Some considerations that must be taken into account especially for biotech/pharma are:

• Market Potential (estimated market size)
• Market Share (penetration rate)
• Sales price Estimate
• Royalty Rate

When forecasting future cash flows for a drug, you need to consider the costs of discovery and bringing the drug to market. The commonly used criteria are:

• Operating Costs
• Clinical Trial Costs
• Capital/Net investment
• Working Capital
• Taxes
  

Deducting the drug's operating costs, taxes, net investment and working capital requirements from its sales revenues, you arrive at the amount of free cash flow generated by the drug if it becomes commercial.

Next Step - Inclusion of risk into our estimates. As the drug moves through the development process, the risk decreases with each major milestone. 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 success translate directly into stock value. By multiplying the drug's estimated free cash flow by the stage-appropriate probability of success, you get a forecast of free cash flows that accounts for development risk.

Applying a legitimate discount rate will allow us to figure out what these cash flows are worth today. So, how do we figure out the company's discount rate? That's a crucial question, because a difference of just one or two percentage points in the cost of capital can make a big difference in the total value. There are many ways of calculating discount rate, and an in depth discussion is beyond the scope of this post, but a safe strategy is to use the Weighted Average Cost of Capital (WACC) which incorporates both debt & equity into the overall picture.

Finally, we can obtain a value for a drug by multiplying the FCF to our discount rate. Repeating this process for the entire portfolio of products and adding up their individual DCF's will give us the Total Enterprise Value of the company.

As you can see, valuing of early stage healthcare entities is possible even by the dilligent individual investor. The issue of contention arises when the methods/models used do not accurately reflect the potential for failure. This, unfortunately, means that there can be several different valuations on the market for the same company. So really, recognizing a good valuation when you see one is the real measure of success.

For more in depth information visit the DCF valuation section under research & papers at Professor Damodar's site http://pages.stern.nyu.edu/~adamodar/