The typical time taken for an Investigational New Drug (IND) from submission to introduction in the market is around eight years. Such long periods of development make the Biopharma industry unique. A biopharma drug does not generate any revenue during the initial years of development resulting in significantly negative cash flows.
Biopharma drug development has to overcome two hurdles, technical and regulatory. The technical hurdle being the various stages of clinal testing to prove a drug’s efficacy and the regulatory hurdle being obtaining approval from regulatory authorities. When valuing a Biopharma pipeline, the success of a drug under testing is unknown as the drug can fail at any stage, which means that the drug will not generate any revenue. This uncertainty in cash flows should be captured in the valuation analysis.
The conventional Net Present Value (NPV) approach assumes a positive outcome at every stage and revenue generation in the future. Under this approach, cash flows do not capture the risk of a failed trial hence, a relatively high discount rate is used to reflect the risk of uncertainty / failure. This method is usually used for non-biotech startups.
The other approach involves capturing risk in the cash flows. This is known as the Risk-Adjusted Net Present Value (rNPV) approach and is used for uncertain/risky future cash flows.
Both these approaches have been discussed in detail below to explain why rNPV should be preferred over NPV and other valuation methods for biopharma valuations.
The Net Present Value (NPV) Approach
The conventional NPV approach involves projecting the cash flows and the costs for each future year for various drugs of a company. The net cash flows are then discounted to arrive at the Net Present Value (NPV). The NPVs of all drugs are aggregated to arrive at the company’s value.
The discount rate used to calculate the NPV depends on the testing stage of the investigational drug, as can be seen in the table alongside. Pharmaceutical R&D projects typically receive financing through equity which results in a higher discount rate.
The main drawback of using the NPV approach for biopharma companies is that the cash flows do not capture the risk of a failed trial. Instead, this risk is reflected in a high discount rate. This depresses the company’s value because the high discount rate will over-discount the value in the later years when the drug will begin generating revenue. The rNPV approach is preferred because it captures the risk in the numerator and prevents this over-discounting.
Risk-adjusted Net Present Value (rNPV) Approach
The rNPV approach involves forecasting future cash flows and costs for each period while considering the probability of the drug’s success at every stage of development.
The forecasted net cash flows are adjusted for uncertainty by multiplying them with the probability of success. These risk-adjusted net cash flows are then discounted to arrive at the Risk-Adjusted Net Present Value of the drug. The rNPVs of all drugs are aggregated to arrive at the company’s value.
When performing rNPV valuation pharmaceutical companies use different discount rates depending on their current cost of capital. These rates can vary but typically are in the range of 10% to 13%. The probabilities of a drug entering the next stage and the average time taken for a drug to enter the subsequent stage of testing from each stage is given in the table below.
In conclusion, the rNPV approach better reflects the uncertainties related with the various stages of a drug under testing and is, therefore, a better approach to value biopharma companies. However, in practice, the company values obtained from both approaches are quite similar.
References
- https://www.alacrita.com/whitepapers/valuing-pharmaceutical-assets-when-to-use-npv-vs-rnpv
- https://seekingalpha.com/article/3973584-roughly-value-pharmaceutical-pipeline-simple-suggestion
- https://cdn2.hubspot.net/hubfs/3828687/Alacrita_April2019/PDF/Pharmaceutical-Probability-of-Success.pdf
- https://www.toptal.com/finance/valuation/biotech-valuation
- Stewart, J.J., Allison, P.N., & Johnson, R.S. (2001). Putting a price on biotechnology. Nature Biotechnology, 19(9), 813-818.
- Sertkaya, A., Wong, H., Jessup, A., & Beleche, T. (2016). Key cost drivers of pharmaceutical clinical trials in the United States. Clinical Trials, 13(2), 117-126. doi:10.1177/1740774515625964
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