Valuation Analysis and NPV Calculations focused on Monogenic ALS

Still, the goal of reporting plays a tremendous role in determining which measure is used. For example, if management believes that a project will fail given expected market conditions, a particular measurement may be chosen over others for the purpose of skewing the return of the project to make it look less worthwhile. Conversely, management may wish to inflate reported returns from a particular project, so that the project for which they have a personal preference will be chosen.

All other things being equal, using internal rate of return (IRR) and net present value (NPV) measurements to evaluate projects often results in the same findings. However, there are a number of projects for which using IRR is not as effective as discounting cash flows using NPV. IRR’s major limitation is also its greatest strength: it uses one single discount rate to evaluate every investment. Although using one discount rate simplifies matters, there are a number of situations that cause problems for IRR. If an analyst is evaluating two projects, both of which share a common discount rate, predictable cash flows, equal risk, and a shorter time horizon, IRR will probably work. The catch is that discount rates usually change substantially over time. For example, think about using the rate of return on a T-bill in the last 20 years as a discount rate. One-year T-bills returned between 1% and 12% in the last 20 years, so clearly the discount rate is changing. Without modification, IRR does not account for changing discount rates, so it’s just not adequate for longer-term projects with discount rates that are expected to vary.

Another type of project for which a basic IRR calculation is ineffective is a project with a mixture of multiple positive and negative cash flows. For example, consider a project for which marketers must reinvent the style every couple of years to stay current in a fickle, trendy niche market. If the project has cash flows of -$50,000 in year 1 (initial capital outlay), returns of $115,000 in year 2 and costs of $66,000 in year 3 because the marketing department needed to revise the look of the project, a single IRR can’t be used. Recall that IRR is the discount rate that makes a project break even. If market conditions change over the years, this project can have two or more IRRs, as seen below.

Thus, there are at least two solutions for IRR that make the equation equal to zero, so there are multiple rates of return for the project that produce multiple IRRs. The advantage to using the NPV method here is that NPV can handle multiple discount rates without any problems. Each cash flow can be discounted separately from the others.

Another situation that causes problems for users of the IRR method is when the discount rate of a project is not known. In order for the IRR to be considered a valid way to evaluate a project, it must be compared to a discount rate. If the IRR is above the discount rate, the project is feasible; if it is below, the project is considered infeasible. If a discount rate is not known, or cannot be applied to a specific project  for whatever reason, the IRR is of limited value. In cases like this, the NPV method is superior. If a project’s NPV is above zero, then it is considered to be financially worthwhile.

So, why is the IRR method still commonly used in capital budgeting? Its popularity is probably a direct result of its reporting simplicity. The NPV method is inherently complex and requires assumptions at each stage – discount rate, likelihood of receiving the cash payment, etc. The IRR method simplifies projects to a single number that management can use to determine whether or not a project is economically viable. The result is simple, but for any project that is long-term, that has multiple cash flows at different discount rates, or that has uncertain cash flows – in fact, for almost any project at all – simple IRR isn’t good for much more than presentation value.

NPV analysis is sensitive to the reliability of future cash inflows that an investment or project will yield.

Formula:

It can be tricky to put a price tag on biotechnology companies that offer little more than the promise of success in the future. Just because someone in the lab cries “Eureka!”, that doesn’t necessarily mean that a cure has been found. In the biotech sector, it can take many years to determine whether all the effort will translate into returns for a company. But while valuation may appear to be more guesswork than science, there is a generally accepted approach to valuing biotech companies that are years away from payoff. In this article, we explain this valuation approach, which relies on discounted cash flow (DCF) analysis, and take you through the process step by step.

Portfolio Valuation Approach
Think of a biotech company as a collection of one or more experimental drugs, each representing a potential market opportunity. The idea is to treat each promising drug as a mini-company within a portfolio. Using DCF analysis, you can determine what someone would be willing to pay for that drug portfolio.

In other words, you determine the forecasted free cash flow of each drug to establish its separate present value. Then, you add together the net present value of each drug, along with any cash in the bank, and come up with a fair value for what the whole company is worth today. (To learn more, see our Discounted Cash Flow Analysis tutorial.)

A biotech company can have dozens, or even hundreds, of drugs in its developmental pipeline. But that does not mean you should include them all in your valuation. Generally speaking, you should only include those drugs that are already in one of the three clinical trial stages. (For more information, visit the U.S. Food and Drug Administration’s website.) As an investment, 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.

Forecasting Sales Revenue
Forecasting the sales revenue from each of a biotech company’s drugs is probably the most important estimate you can make about future cash flows, but it can also be the most difficult. The key is to determine what expected peak sales would be if – and this is a big “if” – a drug successfully makes it all the way through clinical trials. Normally, you will forecast sales for the first 10 years of the drug’s life. (For further reading, see Great Expectations: Forecasting Sales Growth.)

Market Potential
You need to start by making assumptions about the drug’s market potential. Look at information provided by the company and market research reports to determine the size of the patient group that will use the drug. Analysts typically focus on market potential in the industrialized countries, where people will pay the market price for drugs.

When making assumptions about a drug’s potential market penetration, you have to use your own best judgment. If there is a competitive drug market, with limited advantage offered by the new drug in terms of increased effectiveness or reduced side effects, the drug will probably not win substantial market share in its product category. You might assume that it will capture 10% of that total market, or even less. On the other hand, if no other drug addresses the same needs, you might assume the drug will enjoy market penetration of 50% or more.

Estimated Price Tag
Once you have established a sales market size, you need to come up with an estimated sales price. Of course, putting a price tag on a drug that addresses an unmet need will involve some guesswork. But for a drug that will compete with existing products, you should look at the price of the competition. For instance, pharmaceutical giant Roche’s recently introduced HIV-inhibitor drug, Fuzeon, costs just over $20,000 per year. Multiplying that price by the estimated number of patients gives you estimated annual peak sales.

The biotech company won’t necessarily receive all of this sales revenue. Many biotech firms – especially the smaller ones with little capital – do not have sales and marketing divisions capable of selling high volumes of drugs. They often license promising drugs to bigger pharmaceutical companies, which help pay for development and become responsible for making sales. In return, the biotech firm normally receives royalty on future sales. According to an article written by Medius Associates (“Royalty Rates: Current Issues and Trends”, October 2001), the royalty rate for drugs currently in Phase I of clinical trials is normally a percentage in the single digits. As they move along the development pipeline, royalty rates get higher.

In Figure 1, we break down an estimate of the peak annual sales revenues for a hypothetical biotech drug in a competitive market with a potential market size of 1 million patients, an estimated sales price of $20,000 per year and a royalty rate of 10%.

Drug patents usually last about 10 years. In our hypothetical example, we assume that for the first five years after commercial launch, sales revenues from the drug will increase until they hit their peak. Thereafter, peak sales continue for the remaining life of the patent.

Estimating Costs
When forecasting future cash flows for a drug, you need to consider the costs of discovery and bringing the drug to market.

For starters, there are operating costs associated with the discovery phase, including efforts to discover the drug’s molecular basis, followed by lab and animal tests. Then there is the cost of running clinical trials. This includes the cost of manufacturing the drug, recruiting, treating and caring for the participants, and other administrative expenses. Expenses increase in each development phase. All the while, there is ongoing capital investment in items such as laboratory equipment and facilities. Taxation and working capital costs also need to be factored in. Investors should expect operating and capital costs to represent no less than 30% of the drug’s royalty-based sales.

The next step is to discount the drug’s expected 10-year free cash flows to determine what they are worth today. Because you have already factored in risk by applying the clinical trial probability of success, you do not need to include development risk in the discount rate. You can rely on normal means of calculating the discount rate, such as the weighted average cost of capital (WACC) approach, to come up with the drug’s final discounted cash flow valuation. (To learn more, see Investors Need A Good WACC.)

What’s the Firm Worth?
Finally, you want to calculate the total value of the biotech firm. Once you have gone through all the steps outlined above to calculate the discounted cash flow for each of the biotech firm’s drugs, you simply need to add them all up to get a total value for the firm’s drug portfolio.

Conclusion
As you can see, valuing early-stage biotech companies is not entirely a black art. Intelligent investors can come up with solid stock valuation estimates if they are familiar with DCF analysis and are equipped with a basic understanding of the industry and how major developmental milestones can impact the value of a biotech firm.

By Ben McClure, Contributor – Investopedia Advisor

He does the fundamental analysis article bi-weekly. Ben is director of McClure & Co., an independent research and consulting firm that specializes in investment analysis and intelligence. Before founding McClure & Co., Ben was a highly-rated European equities analyst at City of London-based Old Mutual Securities.