Investing in Early-Stage Biotech Companies: The Basics
Biotech companies are at the cutting edge of healthcare as they develop the medicines and therapies of tomorrow. When it comes to investing in biotech, of particular interest are early-stage biotech companies, which typically do not have products and do not generate revenue. Therefore, many early-stage biotech companies are referred to as pre-revenue biotech companies, in contrast to more mature biotech companies with marketed products generating revenue.
As pre-revenue biotech companies develop their medicines and therapies from the very early stages to clinical trials and later bring their products to the market, their value and share price can increase dramatically, potentially leading to substantial returns for early investors.
Key challenges in investing in pre-revenue biotech companies include estimating the potential for future profits from bringing the new medicines and therapies to the market, determining the likelihood that the biotech company will succeed in generating these future profits (probability of success), comparing our estimates of profits and probability of success–our estimate of value–to the consensus estimates of investors as a whole, and evaluating if our value estimates make it worthwhile for us to invest in a biotech company given its current share price.
Clearly, value is a central concept in biotech investing and successful investing in publicly-traded biotech companies requires an understanding of what value in biotech is, how it is created, the principal drivers of biotech value, and the main approaches used to estimate value. It is also essential to understand the risks associated with biotech investing.
Advantages and Disadvantages of Investing in Pre-Revenue Biotech Companies: Investor’s Perspective
Investing in pre-revenue biotech companies involves inherent risks. Therefore, before diving deeper, it is essential to first consider the main advantages and disadvantages of investing in pre-revenue biotech companies.
From an investor’s perspective, the potential for innovation, explosive growth, and traditional portfolio diversification are among the top advantages of investing in publicly traded biotech companies.
Potential for Innovation. Biotech companies are at the forefront of developing cutting-edge medicines and therapies for disease conditions that affect humanity. Investors become part of this mission, contributing to advancements that could transform our lives and the future.
Explosive Growth. Early-stage investments in biotech companies offer the potential for significant growth of the invested capital. If their research and clinical trials lead to successful medicines, the value of early investments could increase as these medicines reach the market. For example, Vertex Pharmaceuticals, a biotech company that went public in 1991, developed a breakthrough treatment for cystic fibrosis. As the treatment gained approval and popularity, and the company began developing new medicines, its share price experienced remarkable growth. A $1,000 invested in Vertex stock in 2003 would have grown to about $22,000 today, a 2,100 % return, or an average annual rate of return of about 17 %.
Diversification. Adding pre-revenue biotech investments to traditional portfolios, typically composed of stocks from revenue-generating companies and bonds, can enhance diversification and reduce overall portfolio risk. Biotech investments often have low correlation with traditional markets. For example, the S&P Biotechnology Select Industry Index and S&P 500 Index correlation between 2003 and 2023 has ranged between -0.1 and 0.9. The lack of consistent correlation can provide a valuable layer of protection during market volatility.
From an investor’s perspective, investing in early-stage biotech companies also comes with disadvantages, including high investment risk and potentially delayed return on investment. Relatively high share price volatility could also be perceived as a disadvantage, depending on investors’ perspective.
High-risk investment. Investing in pre-revenue biotech companies involves significant risk. Drug development programs might fail, clinical trials might not succeed, regulatory hurdles could arise, the company could encounter difficulties with raising the capital needed to advance programs, and a number of other unexpected setbacks can impact the company's trajectory.
Long Development Timelines. Developing new medicines and therapies often takes years, and regulatory approval processes can add further time to the equation, delaying potential returns on investment. Thus, patience can be a virtue in the world of biotech investment.
Stock Price Volatility. Since pre-revenue biotech companies do not generate income, investors often value these companies based on future potential rather than current financial performance, making them more susceptible to sentiment-driven price swings.
How Is Value Created in Biotech? Understanding Company Valuation
The present value of a biotech company can be defined by all the profits that the company will generate in the future convoluted with the likelihood of the predicted profits materializing. Thus, determining the present value of a biotech company comes down to estimating the amount of cash that can be generated in a best case scenario and estimating the likelihood of this best case scenario to occur. The value is what the company is worth–because this is unknown, investing in biotech is inherently risky.
Value is not equal to price. Price is what we pay for a share of the company. As Warren Buffet once said “Price is what you pay, value is what you get”. Our goal as investors is to estimate the value of a biotech company, compare our estimate of value to the value that all investors have assigned as a whole–its current market value–and decide if an investment is likely to generate return. To this end, we first need to understand what drives a company’s stock price. Investors’ estimate and sentiment as a whole of a company’s value defines its current stock price and stock prices are driven by expectations about future profits. When reality and expectations do not match, investors reevaluate their estimate of the value which impacts the stock price. For example, if investors as a whole expect a positive outcome from a clinical trial, but the clinical trial provides negative results, investors reevaluate their estimate for the company’s future profits and the stock price tumbles. Vice versa, if investors as a whole do not think that a company’s therapeutic program will be successful, but the clinical studies turn out positive, investors again reevaluate their estimate for the company’s future profits and the stock price increases.
To assess the likelihood of generating a return, an investor needs to be able to estimate how their valuation of a biotech company compares to the consensus valuation of all investors as a whole, which is equivalent to comparing the investor’s estimate to the market’s estimate. For example, if investors as a whole think that a company will generate 10 times more profits in the future, but this particular investor thinks that the profits will only double, the stock will be priced at the consensus 10 times higher future profits and thus will likely be priced too high for an investment to be worth it for this particular investor. This is because if the investor’s estimate of future profits is correct and the consensus is incorrect, then the price will likely tumble and leave the investor with a loss. On the other hand, if the investor’s estimate of the future profits is incorrect and the consensus is correct, then the stock price is unlikely to change significantly, resulting in no net capital appreciation.
How can an astute investor avoid the above situations and invest in biotech companies whose stocks are more likely to soar in the future and generate return on investment? First, the investor needs to obtain their own estimation of the company’s future profits. Second, the investor needs to understand what consensus future profits investors as a whole expect and obtain an estimate. Third, after obtaining their own estimate and the market’s estimates of companies’ future profits, an astute investor needs to focus only on companies for which the investor expects the future profits to be higher than the consensus expectation and develop a thesis for why they think the stock is worth more than what other investors think it is worth (i.e., an investment thesis).
What is an investment thesis? An investment thesis is a document that clearly outlines an investor's strategy and rationale for choosing to invest in a particular asset. For a biotech investor, the investment thesis outlines the reasons behind choosing to invest in a specific biotech company. It typically includes an evaluation of the company's science and technology, the potential of its drug candidates, evaluation of any available clinical data, valuation estimate, any differentiating factors that make it an attractive investment relative to other companies, and the overall outlook for the biotech sector.
An important corollary from the above is that a good company is not necessarily a good investment. Further, a good company for which an investor thinks that the current price is significantly below what is expected from their estimate of value might be a better investment than a great company for which the investor thinks that the current stock price is significantly above what they expect from their estimate of value.
What is the Value of a Biotech Company Assigned by the Market? Market Capitalization and Enterprise Value
The two most often used approaches for calculating the value of a publicly traded biotech company are equity value (or market capitalization) and enterprise value. The value of a biotech company can be estimated by its market capitalization, which reflects the total equity value of the company. Market capitalization is calculated by multiplying the current market share price by the total number of outstanding shares:
Market Capitalization = Share Price x Number of Outstanding Shares
Current share price and market capitalization information about a company is widely available via financial news websites, for example Google Finance. The number of outstanding shares can be found on the Securities and Exchange Commission (SEC) EDGAR website.
For a pre-revenue biotech company, market capitalization is a straightforward measure of a company's value and reflects the total market value perceived by investors as a whole. While informative and easy to obtain, market capitalization provides a somewhat limited view of the value of a company since it does not account for a company's debt and cash positions. For example, consider a company developing a new vaccine. If the market capitalization of the company is $1.0 B, it is tempting to assign this market capitalization as the perceived value of the vaccine program, which reflects the profit expected to be generated in the future, discounted back to account for the time value of money, multiplied by the likelihood of the vaccine product delivering this profit. Consider a scenario in which the company had $0.5 B in cash reserves. Because, to a first approximation, equity holders have a claim on all company assets, including cash, the perceived value of the vaccine program would be only $0.5B. In the extreme, if the company had $1.0 B in cash reserves, the value of the vaccine program and the associated expected future cash flows would be worth nothing to investors as a whole. Consider another scenario in which the company had $1.0 B market capitalization and $0.5 B in debt. The perceived value of the vaccine program would now be $1.5 B.
The time value of money is a financial concept that says money's worth changes over time. This is primarily because money can earn interest or be invested to grow over time. To understand the time value of money, we need to understand two main concepts: the future value of money and the current value of money. The concept of future value relates to the fact that money invested today will increase in value due to interest. As a consequence, the concept of present value indicates that a sum of money to be received in the future is worth less today, considering a specific interest rate. Essentially, the concept of time value of money recognizes that having money today is more valuable than having the same amount in the future because the money today could be used to earn interest.
Enterprise value incorporates debt and cash and is thus a more holistic representation of a company’s value. Enterprise value is calculated by adding the current debt and subtracting the available cash from market capitalization:
Enterprise Value = Market Capitalization + Debt - Cash
Information about a company’s debt and cash positions can be found in its financial statements, which can typically be found in its annual report (Form 10-K) and quarterly reports (Form 10-Q), filed with the Securities and Exchange Commission (SEC). These reports can be found via the SEC EDGAR website.
How can an Investor Estimate the Value of a Biotech Company? Discounted Cash Flow and Comparables Analyses
To determine if an investment is likely to generate a return, an investor needs to compare the value that the market assigns to a particular biotech company, defined by its market capitalization or enterprise value, to the investor’s own estimate of the company’s value. There are several common approaches available to investors.
Discounted Cash Flow (DCF) Analysis
DCF analysis estimates the present value of future cash flows. Because pre-revenue biotech companies do not have current cash flows, DCF analysis projects future cash flows that the company could generate in principle.
Cash flows refer to the movement of money into or out of a business during a specific period. Positive cash flows indicate that a business is generating more cash than it is spending, while negative cash flows may suggest financial challenges. Cash flows data can provide valuable information on a company's financial health and ability to meet its financial obligations.
The estimation of future cash flows first requires an estimation of the company’s revenue. In the simplest scenario, a biotech company is developing a new drug for a single indication, thus making this single asset the main driver of company value. Estimating the potential revenue generated by a new marketed medicine requires estimating the size of the patient population that will have access to the company’s medicine, the market share that the company can capture, pricing and potential for reimbursement, among other aspects. Importantly, the potential future revenue generated by a new marketed medicine depends on the company being able to discover new drug candidates, develop drug candidates that will show safety and efficacy in the clinic, and gain regulatory approvals. Because none of these events is guaranteed, the DCF model requires a probability to be assigned to each. For example, we know that the general success rate for a drug candidate with a positive phase 2 clinical trials to also have a successful phase 3 clinical trials is about 90% and we can assign this value as the probability for the company’s drug candidate to succeed in phase 3 trials after successful phase 2 trials.
To estimate the future profits or income, we also need to estimate the expenses associated with developing, manufacturing, and selling the new medicine; these are costs related to research and development, clinical trials, and regulatory approval, as well as cost of goods sold, general and administrative costs, marketing and sales costs, and post-market surveillance costs. Income then can be obtained by subtracting the estimated revenue from the estimated expenses:
Income = Revenue - Expenses
To calculate the cash flows, the estimated income is adjusted for accounting-related items such as non-cash expenses and working capital (e.g., accounts payable and accounts receivable). Finally, to estimate the current value of a company from its future cash flows, we need to take into account the time value of money and discount back the future cash flows to the present. The general equation for DCF is as follows:
DCF = Σ CFn / (1+r)^n
where DCF is the discounted cash flow or present value of future cash flows, CFn is the expected cash flow for n periods of time, r is the discount rate, and n is the number of time periods into the future. By dividing the present value of future cash flow by the number of outstanding shares, we can obtain a share price that reflects our estimate of value independently of the market estimate of value for this company.
It is critical to understand that any estimates of current value obtained via DCF analysis heavily depend on the values that the investor inputs for the various stages of discovery, development, and commercialization, as well as the probabilities that the investor assigns to each and the respective timelines. Because DCF is mathematical model, it is by definition quantitative. Nevertheless, because the input values are estimates and based on assumptions, the model’s output can be only as good as the assumptions made. Therefore, it is clearly advantageous to have a scientific and drug discovery and development background.
Comparables Analysis
In a nutshell, the comparables analysis consists in identifying companies that are similar to the company for which the value is to be estimated by the investor and then compare their valuations. The underlying assumption here is that similar companies will have similar valuation.
Because pre-revenue biotech companies do not have marketed products and revenue, the comparisons are based on the therapeutic area, number and type of programs, and each program’s development stage, among other aspects. Having a drug discovery and development background again provides an edge since more accurate company comparisons also require in-depth understanding of the mechanism of action, the potential liabilities of drug candidates, the potential for regulatory approval given clinical trial data, as well as evaluation of the relative strength of intellectual property and market opportunities.
After identifying a set of similar companies (comparison set), a financial ratio can be calculated for each company. Typically, the financial ratio includes some type of measure of value and some type of measure of revenue; a typical financial ratio that can be used for the comparison of pre-revenue biotech companies is enterprise value over peak sales. Because the companies being compared are pre-revenue, the peak sales are to be estimated.
The comparables analysis based on financial ratios can be used in different ways. If financial ratios can be obtained for both the comparison set and the company of interest, an investor can obtain a relative valuation for the company of interest. A relatively higher average enterprise value to peak sales ratio for the comparables set would indicate that the company of interest is undervalued and that an investment could potentially generate return. Vice versa, if the company of interest has an enterprise value to peak sales ratio higher than the average for the comparables set, an investor could conclude that the company of interest is overvalued, and therefore an investment would be unlikely to generate return.
An average financial ratio for a comparables set can also be used to estimate the value of a company of interest. The product of the enterprise value to peak sales ratio for the comparable company and the peak sales for the company of interest yields an estimate of the enterprise value for the company:
(EV/Peak sales)comp set x Peak sales X = EV X
where EV is the enterprise value, comp set refers to the comparison set of biotech companies, and X refers to the company of interest. This estimate of the enterprise value can then be compared to the enterprise value calculated from the company’s market capitalization, cash, and debt to determine if an investment is likely to generate return. In addition, the enterprise value can be used to calculate the market capitalization and given the number of outstanding shares, to calculate a share price which can then be compared with the current market share price.
An alternative way to estimate the value of a company via comparison is to look at the price at which similar companies have been acquired. This approach is known as comparable transaction analysis. Successful biotech companies can get acquired by larger and well-established companies. Because information about the financial conditions of the acquisition can be found, the price paid to acquire a company can be assumed to reflect its enterprise value. Market capitalization and price per share can then be estimated by adding the debt and subtracting the cash from the enterprise value.
Scientific and Clinical Data are Main Drivers of Value for Pre-Revenue Biotech Companies
For pre-revenue biotech companies, future cash flows are determined by the success of their medicines and therapies and therefore their value is, to a large extent, determined by the strength of scientific and clinical data. For example, scientific data reveal the mechanism of action of a drug candidate, while clinical data determine if a drug candidate is safe and efficacious. Scientific and clinical data define the likelihood for regulatory approval and market entry that are required for future cash flows to materialize, and therefore are the critical pieces of information that investors use to assign value to a company. Pre-revenue biotech companies usually experience the most significant share price swings when critical scientific or clinical data is reported by a company. Because scientific and clinical data can be considered the main currency for pre-revenue biotech companies, it is essential to have a scientific and drug development background or consult with drug discovery and development scientists when investing in biotech companies. A good understanding of the drug discovery and development processes and clinical trials is an essential first step towards an understanding of the nuances and complexities associated with the development of new medicines and therapies and is the basis for meaningful valuation of pre-revenue biotech companies.
In addition to scientific and clinical data, several other factors impact biotech company valuations. The current stage of drug discovery and development can significantly impact company valuation: all else being equal, the more advanced the development stage, the higher the valuation of the company. This is because each development stage has a certain probability of failure, and a company with a drug candidate in a more advanced stage has a higher probability of materializing the predicted cash flows. The leadership team can also have a significant impact on the company’s value. This is because, all else being equal, a more experienced leadership team is more likely to bring drug candidates to the market and materialize the predicted cash flows.
Summary
In summary, investing in publicly traded pre-revenue biotech companies presents both enticing opportunities and inherent risks. Biotech companies are often at the forefront of medical innovation, developing the medicines and therapies of tomorrow, and thus hold the potential for explosive growth while also allowing for the diversification of traditional portfolios. Understanding how value is created, how company valuations can be obtained and compared, and how to compare companies, is paramount for successful biotech investing. Further, successful investing in pre-revenue biotech companies is particularly difficult because it requires a good understanding of and experience in a number of domains and disciplines, including general investing, finances, science, and drug discovery and development: the significance of having a scientific background or consulting with experts for a nuanced understanding of drug development can never be overstated. In evaluating pre-revenue biotech investments, investors must weigh the advantages of innovation and growth against the challenges of high risk, prolonged development timelines, and stock price volatility. A comprehensive investment thesis, grounded in a realistic assessment of a company's scientific and clinical data, and realistic assumptions, is crucial for navigating this dynamic and potentially rewarding field.
Disclaimer: This article provides general information about investing in biotech companies and does not constitute financial and investing advice. Investors should conduct thorough research, consider their risk tolerance, and consult with financial professionals before making investment decisions. This content is for educational purposes only. Investing in biotech involves inherent risks, and past performance is not indicative of future results.