January 29, 2015

Looking Inside the Biotech Black Box (Part 2)


Some basic mathematics


When you create a valuation spreadsheet, you are plugging in estimates of revenues and expenses which are going to occur over several years, if not a couple decades. When you do the basic addition and subtraction in this spreadsheet, you hopefully end up with a positive number because, if the number is negative, you are valuing something that is not economically viable.

However, we all know that a dollar received now is worth more than a dollar received ten years from now. This is extremely relevant for a biotech company because most expenses occur before any of the revenues. You need to adjust all future revenues and expenses so they are calculated in current dollars and the sum is called the ‘net present value’ or NPV. You can get more detailed information on NPV calculations from statistics textbooks or entering NPV in your web browser or spreadsheet help function.

The key factor in this calculation is the discount rate or ‘risk-free cost of capital’. Pfizer was able to do a debt financing in 2014 at 1.1% for short-term notes and 4.4% for 30-year notes. At this time, I would use a discount rate of about 8% to 10% for a smaller company with approved and marketed products.

While we all generally accept that a current dollar is worth more than a future dollar, you actually have to do the calculation to see the impact of time on the value of your money. The table below shows the NPV of a guaranteed $100 payment received nowGraphBBPart2R or from one to ten years from now, using discount rates of 8% and 20%.

This concept is very important when looking at licensing deals. A press release announcing a licensing deal will usually include two numbers – the value of any upfront payments and the ‘biobucks’ number, which is the potential total value of all upfront and milestone payments under the licensing deal (the likely structure of those milestone payments will be discussed in a later blog). If a deal is signed for a Phase 1 product, those milestones will likely occur over the next 10 to 15 years. Even if we use the current risk-free cost of capital – and a Phase 1 product is definitely not risk-free, the NPV of the biobucks number is likely to be no more than half of the biobucks number.

I used the term ‘risk-free’ above because it does not take into account the risks associated with biotech, which can be large and numerous. There is a continuous need to understand and balance the risks and potential rewards. To emphasize the risks associated with investing in this sector, prospectus offerings for Canadian biotech companies from about 10 years ago contained a statement similar to the following.

An investment in the common shares of Company X should be considered highly speculative due to the stage and nature of our business and should only be made by persons who can afford a total loss of their investment.

The statement in current prospectus offerings is not as extreme but it does reference from 3 to 10 pages of product, company, regulatory and general risk factors.

An investment in the Offered Securities involves a high degree of risk. Prospective investors should consider the risk factors described under “Risk Factors” in this prospectus and in the Company’s Annual Information Form.

[The 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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