A business model in the biotech sector has unique features that differentiate it from the general market. This is reflected in the specific approach and particular methods of evaluating biotech assets for investment purposes.
A medical biotech company creates, develops, and implements innovative drugs, devices, or treatment, diagnostics and prevention methods that provide more effective means of combating human diseases.
The main difference between a biotech company and other medical companies is the focus on developing innovative drugs, whereas pharmaceutical companies produce and sell drugs that have been used in healthcare for a long time.
The average investment period in biotech is 5 to 15 years. During this time, the company goes through all the stages of developing first-in-class drugs and, by the time of market entry, it has sustainable technological, regulatory, and patent advantages. This allows them to receive a stable marginal cash flow protected from the impact of competition.
Due to the long drug development cycle, complex models are required to evaluate biotech companies. This is due to the fact that the company is not yet generating revenue at the drug development stage, so cash flows are usually negative. Therefore, it would be wrong to evaluate a biotech company based on its current financial performance.
Using risk-adjusted discounted cash flow (rDCF) method can help you more accurately understand the value of the company and see a major upside.
It would be wrong to evaluate a biotech company using methods based on current financial indicators (especially at the drug development stage). However, many investors need help evaluating a company based on its future cash flows. As a result, biotech projects often have a major upside in their value.
Medical and pharmaceutical companies have a shorter investment period which may include, among other things, the creation and development of medical institutions, pharmacies, factories, and warehouses. This period is generally between 1 and 5 years. For this reason, standard assessment valuation methods based on financial indicators are more often used for such companies.
The development and implementation of drugs is a long and costly process. On the one hand, there are strict rules imposed by regulators, on the other hand, companies incur significant costs following the necessary procedures for the evaluation of effectiveness and safety of new drugs at the stage of preclinical and clinical trials (PCT and CT).
Therefore, biotech companies usually require several rounds of financing throughout the drug development period (5 to 15 years) before achieving stable revenues and profits. At this time, they may face losses, risks of failure to complete development stages and lack of funding. However, if successful, they can achieve high revenue and profit growth rates. It should be noted that even at the drug development stage, a biotech company can increase its valuation significantly. This happens when a company enters into a licensing or codevelopment agreement with a large pharmaceutical company. In effect, such transactions give the large pharmaceutical company the rights to the developments for which it agrees to pay royalties, confirming future cash flows. This increases the value of a biotech company significantly as cash flows become more predictable and easier to estimate.»
Estimate the size of the patient population that will use the drug based on information provided by the company, disease market research reports, and data from independent sources. If a drug can be used for several different diseases, its market potential for each one should be evaluated.
Biotech companies often commercialize their innovative drugs by licensing to pharmaceutical companies. This may include financing at various development stages, organizing production and sales. In return, the biotech company usually receives royalties on future sales.
To determine the price of a drug under development, you need to look at competitors’ prices and estimate the cost of alternative treatments. Based on this data, the price of a new drug can be predicted.
First, you need to forecast the time to peak sales, then forecast sales during the patent validity period, usually about 20 years, and, finally, forecast post-patent sales.
Development.
Determining the drug price (taking into account the coverage of unsatisfied demand) will require certain forecasts. For a drug that will compete with existing treatment options, study the cost of such treatment options and the prices of potential competitors.
Sales.
Estimate the product cost per unit, the level of fixed operating expenses, and capital investments.
The free cash flow forecast builds on the drug’s success in all trials, regulatory approval, widespread use, and inclusion in clinical guidelines and insurance systems. However, not every drug reaches the market. Therefore, depending on the stage of development, the likelihood of success and development risks must be taken into account. By multiplying the estimated free cash flow by the probability of success at a certain stage, you can get a free cash flow forecast considering the development risk.
Investments in early-stage biotech projects can be profitable, but there is a risk that the development will not reach the market. So the value of a biotech company depends on its progress at the key research and development (R&D) steps that reduces the risk. The results of preclinical and clinical trials, inclusion in guidelines, obtaining a market authorization, and other achievements of the project are assessed by investors and may lead to the company’s value being revised.
Each drug is evaluated individually based on its indications, i.e., the diseases it treats, and market potential. A DCF analysis can estimate the cost of an individual drug or a portfolio of drugs.
During the valuation of a biotech company, it is worth considering the probability of success of each phase of clinical trials. To do this, adjust the estimated cash flow by the probability of success at each phase of the project.
Source: Hay, Michael, et al. «Clinical development success rates for investigational drugs» Nature biotechnology 32.1 (2014): 40-51
Changes in the cost of development as exemplified by Neovasculgen for the CLI (chronic lower limb ischemia) indication depending on the R&D stage.
The drug for this condition is at the second phase of clinical trials. Artgen Biotech’s expert assessment of the cumulative probability of success and MA issue is 56%.
Current estimation of the drug cost for the DFS indication taking into account the risks of the third phase of clinical trials and including the drug’s indication for the use in the MA.
*rNPV — modified NPV (net present value) with each cash flow adjusted for the estimated probability of its occurrence
Artgen’s team has prepared a sample investment model for the X disease market to demonstrate an approach to biotech asset valuation. If you want to assess a particular disease market yourself, download the calculator in Excel and change the parameters as needed.
