Valuing pharma companies isn’t the same as valuing non-pharma companies, for several reasons.
Traditional business considerations are compounded by patent law and FDA approval processes when evaluating the investment potential of pharmaceutical companies.
The life cycle of prescription drugs is relatively brief, with high-margin revenue falling to zero almost overnight when drug patents expire. Pharmaceuticals are high-growth, high-profit, and high-risk. Furthermore, the drug development pipeline is important enough that companies with little to no revenue may nonetheless be worth billions of dollars.
Though there is no single “right” way to value pharma companies to inform investment or acquisition, there are several key factors worth examining. Here are five of them.
1. Discounted Cash Flow (DCF)
DCF analysis is an attempt to determine the value of a company today based on projections of how much value it will create in the future. In other words, it determines the current value of expected future cash flows by way of a discount rate. DCF can be a useful tool for confirming fair value prices published by analysts. It is, however, tricky and based on many assumptions, including the value of the pipeline for as-yet unapproved drugs.
2. Forward P/E Ratio
The ratio between a company’s stock price and its earnings per share helps investors understand the value of a company when compared to the company’s historical P/E or competitor P/Es from the same industry. Forward P/E is calculated using earnings per share calculations based on future estimates, often provided by equity research analysts. The rationale for using this in evaluating pharma companies is that the company typically has valuable products that have not launched or are in early launch stages. How many years in the future you estimate EPS depends on factors like the development stage of new drugs.
3. “Strategic Exit” Factors
In pharmaceuticals, it’s not unusual for small and medium-sized companies to be valued partly based on the likelihood of their being acquired by a larger pharmaceutical company. Therefore, many pharmaceutical investors attempt to identify good M&A candidates and develop a value for the companies based on how much bigger pharma companies are likely to pay. While this technique shouldn’t be a primary valuation method, it can be helpful in understanding the overall current market state.
Mergers and acquisitions have accelerated in the pharmaceutical space, so an investment’s acquisition potential can be worth exploring.
4. Biosimilars vs. Generics
When drug patents on small molecule drugs expire and generic drugs enter the market, revenue for branded drugs can drop more than 90 percent almost instantly. In other words, after drug patent expiry, you can safely assume the drug is worth nothing.
This is not necessarily true for biosimilars. The U.S. is slower than many other countries in commercializing biosimilars, and the FDA pathway for biosimilar approval is new and more complex than that for approving small-molecule generic drugs. Therefore, the value of biologic drugs hangs on longer when biosimilars are introduced, compared to the steep drop in the value of small-molecule drugs when generics are introduced.
5. Risk-Adjusted Net Present Value (NPV)
Ordinary NPV calculation requires knowledge of expected cash inflows and cash outflows plus the probability of technical and regulatory success. Risk-adjusted NPV also requires knowledge of the relevant success rates for each stage of drug development. Plenty of historic data exists concerning probabilities of success for pharma R&D projects.
Cash flow projections for pharma products are unique and must be built from scratch. Cash flows are driven by factors like drug development phases and revenue/market phases. When valuing a small pharma company developing a potentially successful new drug, you have to account for factors like:
- Number of potential patients who have the target condition or illness
- Pricing estimates (which can be difficult since pricing information is sometimes hard to pin down)
- Gross margins for drugs (typically very high)
- Sales and marketing expenses (also typically high)
It’s also important to bear in mind that revenue curves will be different for the development of curative therapies compared to therapies that manage conditions.
Valuation of pharma companies requires knowledge not only of traditional valuation tools and calculations, but also of the FDA drug approval process, drug patent status, the prevalence of illnesses drugs are meant to treat, and so on. By using multiple tools, you can gain a more well-rounded sense of the value of a pharmaceutical company and make a more informed choice on investing.
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