January 14, 2015

Looking Inside the Biotech Black Box (Part 1)




In mid-2011 I started a 26-part blog series titled ‘Valuation & Other Biotech Mysteries’. Some aspects of the valuation blogs have not changed, such as NPV calculations. Other aspects have changed substantially – and will continue to change, such as the state of capital markets, investor interest in biotech, reimbursement problems, and the hot drug and disease targets. As a consequence, I am going to revise, update and make additions to the original blog series and start the publication of a new blog series – Looking Inside the Biotech Black Box. I chose the title of this new blog series because many people view biotech as a mysterious black box into which you throw a lot of money, wait a decade and see whether any products or profits on your investment emerge from the black box.

I have been doing valuations in various forms since 1981 when I started my MBA at York University. There are major differences between those academic valuations and the ones that I did during my four stints as a biotech stock analyst during the 1992 to 2008 period. Those initial valuations were for physical assets or profitable companies, much easier than valuing biotech companies with products which may never get to market and for which potential peak sales are ten or more years away. The advantages to doing valuations now – the amount of easily available information and the ability to rapidly create and modify financial models – are balanced somewhat by the increased rate of change and volatility of pharmaceutical and capital markets.

When I taught the valuation section of a licensing course, I ranked the importance of three aspects of valuation as follows.

    •  The least important aspect of the valuation is the spreadsheet. Almost everybody has access to a computer and can create a spreadsheet, plug in some numbers and value a company using standard formulae.
    •  The assumptions which are used to generate the input numbers for the spreadsheet are more important because poor or flawed assumptions on factors such as success rates, market potential and event timing will result in poor quality valuations.
    •  The most important aspect of valuations is how you use them to make decisions. Decisions in which valuations are important include the structure of licensing deals and the prices paid to acquire products or companies. Valuations can sometimes be useful in making decisions about biotech stock purchases or sales.

I recently taught a Chem 894 session at Queen’s University on Financial Accounting & Analysis, with the audience being graduate students in the Department of Chemistry. The following 3-step process was introduced to give them a template for case studies and projects.

    •  Understand the business so you know the right questions to ask
    •  Better information is obtained if the right questions are asked
    •  Realistic numbers and better decisions should result if good information is used to generate the financial assumptions

This series of articles is being written for the person who has little or no knowledge about biotechnology. Information is a key component of the education process and there are numerous free and easily accessible information sources and databases. More importantly, asking the right questions and accessing useful information removes some of the mystery and allows you to understand and balance, but not eliminate, the risks of the development process for drugs, devices and diagnostics.

Let’s start “Looking Inside the Biotech Black Box”.

When you create a valuation spreadsheet, the column headings usually define the period over which the valuation is being calculated. The first important question is ‘what events will occur and when will they likely be happening during this period?’ The next several parts of this series will look at the events which occur during the product development and regulatory approval processes.

[Th author and his immediate family members may have long or short positions in the shares of some companies mentioned in or assessed during the preparation of this blog. Past share price performance may not be an indicator of future share price performance. This blog does not consider the investment objectives, financial situation or particular needs of any particular person. Investors should obtain professional advice based on their own individual circumstances before making an investment decision.]

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