How to Value a Development-Stage Biotech Company

Fair warning: If you don’t like math, today’s post might end up being a little painful.

Regardless, I urge you to bear with me until the end, as I’ll be sharing an incredibly valuable tool for anyone who happens to be interested in biotech stocks.

I’ve decided to share this tool today because right now, there is a ton of concern in the sector that we’re sitting on a bubble. Fear of a bubble means that finding the correct value of a biotech’s pipeline is more important than ever, for when bubbles pop, speculation takes the biggest hit.

Biotech companies trading on the NASDAQ have returned 500% gains to shareholders since 2011 versus 97% from the exchange’s Internet stocks.

Jointly, the overall technology market trades at 15.81 times annual sales overall, while the biotech sector doesn’t have a P/E due to an overall loss on the bottom line. 

If you think this industry is bloated, I’m right there with you.

Of course, this doesn’t mean there aren’t any biotech stocks out there worth buying at all right now — it just means they’re a lot harder to find.

With this sector as expensive as it is, you need to make sure you’re getting the most bang for your buck. You also need to make sure you’re accounting for the inherent and unique risks of drug development.

When valuing any development-stage biotech, the most important factor to consider is regulatory risk. The potential market for a drug could be billions of dollars, but if it never gets approved, that figure drops down to zero.

This is why when determining how much a biotech company is worth, it’s crucial that you adjust for this risk. Particularly, you need calculate what’s called “risk-adjusted value,” or RAV, for the entire company pipeline.

The formula for RAV looks like this:

RAV = Market Potential * Market Share * Likelihood of Approval (LOA)

Consider the following scenario, where Company X has four drugs in its pipeline.

First, you calculate the value of each drug by multiplying its market potential by its projected market share. This calculation gives you the value of each drug assuming approval.

You can then adjust for risk that the drug will not pass through regulation by multiplying the value of each drug candidate by its likelihood of approval (LOA). This gives you your risk-adjusted value (RAV) for each drug, which can be added together to determine the total pipeline value of the company.

Obviously things like likelihood of approval and market share will be difficult to put a number on, so this is where things get a little tricky. As a retail investor, you’re at a significant disadvantage unless you’re either a) a doctor or b) willing to do a ton of research on things like historical approval rates.

If you happen to have some pretty deep pockets, though, you’re in much better shape. You can spend a pretty penny (around five figures) annually on a service to give you some of the most accurate data in all of biotech.

That service is called the BioMedTracker Drug Intelligence Platform, and it’s the single most useful database for biotech investors, plain and simple.

Essentially, what these guys do is look at historical approval rates broken down by drug type, disease target, etc. They then have a team of doctors who will look at the trial data and adjust LOA accordingly.

BioMedTracker even keeps the voting records of the experts sitting on FDA panels. This can obviously be incredibly useful for catalytic events, as stocks will rise and fall based on the direction these panel members vote.

Here’s an example of what the valuing method might look like for Company X described above:

In this particular scenario, the pipeline of Company X has a maximum potential of $2.4 billion and an RAV of $600 million. In other words, after adjusting for market share and risk, it’s safe to say the company’s pipeline assets are worth somewhere around $600 million.

Now, to find the appropriate share price, you’ll need to account for cash and debt and then divide by the total number of shares available:

Share Value = (RAV + Cash – Debt) / Shares Outstanding

So if Company X were to have $30 million in cash, $10 million in debt, and 70 million shares outstanding, you would calculate share value as follows:

($600 million + $30 million – $10 million) / 70 million =

$620 million / 70 million =

$8.86

In this scenario, a fair share value is $8.86, so you can consider Company X a buy so long as its current share price sits under that mark.

Of course, unless you’re well equipped to get all the relevant information, the value of the above formula isn’t particularly useful.

A solid place to start for drug approval rates (LOA) based on disease type comes from Michael Hay’s research on Clinical Success Rates for Investigational Drugs (see Table 4 and Table 5) recently published in Nature Biotechnology. That and some market research should be enough to get you started.

And while it certainly takes a bit of legwork, using this formula can be the difference between actually investing and playing a figurative game of roulette.

I wouldn’t recommend buying any dev-stage biotech without it.

Until next time,

Jason Stutman

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