By John Hempstead
There are a number of circumstances when it is necessary to determine the value of a life sciences company. Examples of such situations would be:
the acquisition or sale of a company
valuation for purposes of granting stock-based compensation to employees
valuation in connection with financing
valuation for financial reporting purposes
valuation for estate planning
valuation in connection with divorce.
Normally, the appraiser is seeking to determine the fair market value (or fair value) of the company as a whole or the value of its securities. There are three generally used approaches to valuing a company: the asset approach, the market approach, and the income approach.
The asset approach involves the adding up of the value of all of the company’s assets, based on their historic or current costs of acquisition, and subtracting from this sum of the asset values the total amount of the company’s liabilities. This approach is most appropriate for valuing a recently formed company, one which has not yet developed any significant amount of goodwill or other intangible components to its value. Life sciences companies usually possess a considerable amount of internally generated intangible asset value. Therefore, the asset approach is not often used in their valuation.
The market approach is based on the principle of substitution, under which a buyer would pay no more for a given property than it would cost to acquire an equivalent substitute property. In other words, if two companies, company X and company Y are similar, and we know how much someone recently paid to buy the stock of company Y, then the transaction price involving company Y will provide us with an indication as to the value of company X. This approach to value is often referred to as the market comparable approach.
In a typical example of the application of this approach, the target company (the company being valued) is a private company with no publicly traded securities. The comparable company, or companies, would be public companies whose stock is regularly traded, with publicly available stock quotations. The analyst would calculate certain ratios based on the market price of the public companies, such as the price to earnings ratio or the market value to revenue ratio. These ratios, with appropriate adjustments, would then be applied to the corresponding metrics of the target company in order to provide an estimate of what the trading price of the target company’s stock would be if it were publicly traded.
It is often necessary to apply an adjustment to the value derived from the market comparable approach in order to take into account the fact that the stock prices of the public companies used in the analysis represent minority interests, whereas we may be valuing a controlling interest in the target company. The adjustment in such a case would be to apply a premium, known as a control premium, to the value derived from minority transactions in order to reflect the enhanced value of a controlling interest as compared to a minority interest.
Another example of the application of the market approach would be to examine the terms of merger & acquisition transactions involving companies which are similar or comparable to the target company. As with the publicly traded market comparable approach, certain valuation ratios would be calculated and applied to the target company in order to determine its value.
The market comparable approach to valuation is primarily applied to life sciences companies that have reached the point in their development of having regular earnings, revenues, and/or cash flow. Market valuation principles are also sometimes used in developing inputs to income-based valuations. An example would be estimating the expected sales of a new drug by looking at the sales of a comparable existing drug.
Many life sciences companies, particularly early-stage firms, do not have an established record of earnings, cash flow, or even revenues. Therefore, they are not candidates for the use of the market comparable approach to valuation.
When an appraiser is valuing a company whose future is expected to differ markedly from its past, they will frequently employ a valuation approach which relies primarily on estimates or projections of future cash flow. Such an approach is referred to as an income approach or discounted cash flow (DCF) approach.
In carrying out a DCF valuation, the analyst will prepare a financial projection for the company over some designated future time period. This projection will provide an estimate of the cash flow expected to be generated by the enterprise. The cash flows are then discounted back to the present using an appropriate discount rate to reflect the time value of money. For example, $1 million received five years in the future would be worth only $402,000 today, using a discount rate of, say, 20% per annum. At a discount rate of 30% per annum, the present value of $1 million would be $269,000.
Obviously, the discount rate selected has a marked effect on the outcome of the analysis. The rate selected should reflect the target rate of return that an investor is likely to seek when making such an investment. It should also take into account the riskiness of the investment. The higher the perceived level of risk, the higher the required rate of return should be.
There are a number of analytical techniques used to establish an appropriate discount rate. One is called the capital asset pricing model (CAPM), which derives its input primarily from the market performance of publicly traded securities. Another is the market derived capital pricing model (MCPM), an analytical approach which incorporates the annual cost of providing to the investor a put option which will protect him from loss. Finally, and most commonly, investors will require a rate of return which is consistent with what they are accustomed to seeing in the market, tempered by what they perceive to be the riskiness of the particular investment.
Real Option Analysis
Life sciences companies, particularly early-stage product development companies, have R&D development paths that are longer and more complex than those of many other industries. Each stage, from preclinical testing through approval of a new drug application by the FDA, represents a critical project milestone. The cumulative probability of successfully taking a drug through all clinical trials and FDA approval is estimated to range from about 5% to 28%, depending on the disease group. At each decision point, management has the option to cut its further losses by abandoning the project if the outlook at that time doesn’t warrant its continuation. This option to abandon and thereby avoid further loss is a legitimate element of value to the project. An appraiser can incorporate this value into his overall value of the company or project by using what is known as the real options approach to valuation.
To carry out this approach, the analyst prepares a decision tree that incorporates all of the key decision points of the project, along with the expected cash flow result of each outcome and the probability of the occurrence of each outcome. The cash flows are then adjusted to account for the probability of their occurring, and then the sum of the cash flows from all of the scenarios is discounted to the present to establish the value.
In preparing a multiyear projection to be used in a cash flow valuation analysis, a key input is the revenue projection, as this is the basic source of all positive cash flows. Revenue is often estimated by using the concept of peak sales, or the maximum annual rate of sales that the drug will reach in its life cycle. Peak sales are often estimated by comparing the target drug with other similar drugs that are already on the market. These comparisons are then adjusted to take into account competition, the expected time required to reach peak sales, the life cycle of the drug, and the expected erosion rate of sales due to generic competition upon patent expiration. The careful analysis of potential revenue is a very important part of a cash flow analysis.
Complex Capital Structures
Many life sciences companies have been funded by investors in successive rounds of financing. These financings are usually accomplished with successive series of preferred stock. At some point it may become necessary to determine the value of a particular issue of stock or to allocate the value of the company among the various issues of outstanding preferred and common stock. There are three generally accepted methods of performing this allocation. These methods are the current value method, the option pricing method (OPM), and the probability-weighted expected return method (PWERM).
The simplest of these three methods is the current value method, which allocates the current value of the company to the various classes in accordance with their liquidation preference or conversion value, whichever is greater. Although the methodology is clear and straightforward, it lacks the forward-looking perspective necessary to value many early-stage securities.
The option pricing method models each class of stock as a call option with a claim on the value of the company. The characteristics of each class of stock determine the class’ claim on the equity value. The OPM uses Black-Scholes or other option models to calculate value. This method is useful for valuing securities when there is a high degree of uncertainty regarding potential future outcomes.
Under the probability-weighted expected return method, the value of the stock is based upon an analysis of future values for the enterprise, assuming various scenarios for the company, such as an IPO, a sale, or continued operation. The PWERM is rooted in decision-tree analysis and models potential future expected outcomes. The resultant share value is based on the probability-weighted present value of expected future investment returns. A primary advantage of PWERM is its intuitive nature, making it easy to understand and follow conceptually.
Valuation of a life sciences company, particularly one in its early stage of development, is a complex undertaking. The valuation profession has devised a number of analytical tools to assist in the valuation process. In order for these tools to be effective, however, they must be employed by the appraiser together with a generous helping of common sense.
About The Author
John Hempstead, ASA, CFA, is managing director of Hempstead & Co. Inc. (www.hempsteadco.com), a consulting firm specializing in the valuation of businesses and corporate securities. He is a chartered financial analyst and holds the designation of Accredited Senior Appraiser in the discipline of Business Valuation in the American Society of Appraisers (ASA).