How To Overcome The Challenge Of Valuing A Biotech

By Dimitar Krastev & Marc Richards

Biotechnology companies often offer a promise of future success, but it can take years to determine whether all the effort (and expense) will translate into returns. Because of the unknowns around revenue streams, biotech valuation may appear to be more guesswork than science. However, common valuation methods can help account for some of the product-line uncertainty. The key to success when using these methods lies in incorporating the right considerations into the valuation process.

Companies generally use one of three common valuation frameworks to value their company: the net asset value (NAV) method, a form of the cost approach; the discounted cash flow (DCF) method, a form of the income approach; or a market approach. Biotech is better off using the NAV or DCF methods because finding comparables for the market approach can be difficult. Providers need to consider several factors when approaching valuation, including the size of asset pipeline, development stage of the pipeline (e.g., Phase 1, NDA filing), and the company’s development stage (e.g., prerevenue) to pinpoint similar companies or transactions.

A CLOSER LOOK AT NAV AND DCF

An entity’s NAV is the fair market value of its assets less the fair market value of its liabilities. Analysts using the NAV valuation method estimate the fair market values of the subject company’s assets and liabilities.

Under the DCF method, a valuation analyst quantifies and discounts expected future monetary benefits to present value at an appropriate rate of return. A modified version of the DCF method, called the risk-adjusted net present value (rNPV) method, is often used for biotech companies whose future monetary benefits have some degree of uncertainty. Under the rNPV method, each cash flow of the business or asset is adjusted by the probability that it occurs. rNPV includes attrition risk, which means a lower discount rate is applied under this method relative to a traditional DCF.

Determining the most suitable method for any given company is dependent on whether potential transactions involve the entire company or only the company’s main assets. Transactions involving the entire company are better suited for the DCF method, while transactions involving only the company’s main assets (or drug portfolio) make the NAV method more appropriate.

Analysts also can decide whether to value the subject company based on its main assets or its cash flows. The DCF method (with some differences) will be used in either case.

FORECASTING SALES REVENUE

Forecasting sales revenue from a biotech company’s asset(s) is probably the most important future cash flow estimate, but it also can be the most difficult. Analysts must determine what expected peak sales would be if the asset made it to market.

MARKET POTENTIAL

The forecast usually starts by making assumptions about the asset’s market share and potential. Analysts use market research reports to determine the buyer group size. The greater the additional benefits of the new product, such as increased effectiveness and reduced side effects, the greater its potential market.

PROJECTED SALES

Next, analysts estimate the sales price. Products that address an unmet need will involve some guesswork. For other products, analysts can benchmark the price of the competition. Multiplying the drug price by the estimated number of buyers generates the estimated annual peak sales. However, the biotech company in question won’t necessarily receive all of this projected sales revenue. Many biotech firms are not capable of selling a high volume of products, and as such, often license promising products to bigger companies and receive royalties on future sales in return.

ESTIMATING COSTS

When forecasting future cash flows, analysts will consider the costs of bringing the product to market. For pharmaceuticals, this includes the efforts to discover the drug’s molecular basis, followed by lab and animal tests. If using the DCF valuation method, administrative expenses also will need to be considered.

OTHER CASH FLOW CONSIDERATIONS

Companies valued under the NAV method will have no other cash flow considerations. By deducting the product’s operating costs from its sales revenue, the analyst should arrive at free cash flow.

Analysts using the DCF method need to consider investment in manufacturing equipment and facilities (i.e., capital expenditures), and incremental working capital. By deducting the operating costs, taxes, capital investment, and working capital requirements from sales revenue, the analyst should arrive at free cash flow.

In either case, risk adjustments need to be made in order to determine the fair market value of the subject company.

ACCOUNTING FOR RISK

Products don’t always make it all the way through development. Depending on the product’s stage, an adjustment must be applied to account for the probability of development success. Risk generally decreases with each major milestone. By multiplying the estimated free cash flow by the stage-appropriate probability of success, the analysis should get a forecast of free cash flows that accounts for development risk.

The final step in the valuation process is to discount the product’s expected, probability-adjusted free cash flows to present value.

DIMITAR KRASTEV is a senior manager in CBIZ Valuation Group, based in Atlanta.

MARC RICHARDS is a senior manager in CBIZ Valuation Group, based in Dallas.