Biotech Company Valuation Part 1: Understanding Value and Valuation
Article summary
Company valuation is the process of determining the company’s worth in financial terms and is an essential process that informs internal decision-making, strategic planning of investment and acquisitions, and investment decisions.
Company valuation approaches typically depend on tangible financial metrics, such as generated revenue and earnings, as their foundation. Biotech company valuation is challenging because biotech companies are typically years away from generating revenue or earnings.
The present value of a biotech company can be defined by all the profits that the company can potentially generate in the future, convoluted with the likelihood of the predicted profits materializing, and adjusting the value of future profits to the present. The main challenge in valuing biotech companies is thus estimating future profits within ever changing market conditions and uncertain future.
For biotech companies, the concepts of risk and value are fundamentally intertwined. This is because the development of new medicines and therapies is an inherently uncertain process with scientific, regulatory, and market uncertainties. The more development stages a drug candidate successfully clears, the lower the risk of failure, and the higher the future value of the biotech company.
Derisking can take various forms, including successful completion of clinical trials, regulatory approvals, and enhancing the leadership team with experienced executives, among others.
Introduction
Knowing what a biotech company is worth in financial terms—knowing a company's value—is critical for any financial transaction or strategic decision involving the company. Company valuation is the process of determining the company’s worth by evaluating its financial performance, assets, and future profits potential in the context of an ever evolving market. Valuation is an essential process that informs internal decision-making, strategic planning of investment and potential acquisitions, and venture capital and individual investor’s investment strategies within the biotech sector.
In a series of articles we will explore different aspects and principles of company valuation, the key drivers of company value in biotech, and the various metrics and approaches for determining value. In this first article, we will slowly immerse ourselves into biotech valuation by defining company value and valuation, and exploring the notion of risk and its relationship to value. In this series, articles will initially be tailored to an audience that seeks to grasp some of these concepts while subsequent articles will gradually include deeper explanations.
What is Company Value?
Company value reflects the economic worth assigned to a company based on various factors such as financial performance, market position, assets, and future profits potential. The process of determining a company’s value is called company valuation. Thus, company value is the quantified worth resulting from company valuation, representing what the company is worth in financial terms.
Importance of Biotech Company Valuation for Growth, Acquisition, and Investment
Conducting a company valuation helps in determining the sale price of the company, informs investment decisions and fundraising efforts, and facilitates the planning of acquisitions. Essentially, knowing a company's value is critical for any financial transaction or strategic decision involving the business.
From the company's own perspective, valuation is important because it provides an understanding of the company's financial health and market position, which is important for making informed decisions on strategic growth, investments, and resource allocation. It also enables the company to gauge its appeal to investors and lenders, guiding capital raising efforts. Furthermore, understanding its valuation helps a company in setting goals, evaluating its performance against industry benchmarks, and preparing for potential acquisition or public offerings.
From an investment venture capital perspective, company valuation is important as it determines the worth of companies considered for investing in, guiding how much capital to invest for a specific equity stake. Company valuation helps in assessing the potential return on investment, managing the risk associated with early-stage investments, and strategizing exits through sales or public offerings, ensuring that the venture capital firm maximizes its investments' value.
From the perspective of biotech investors, company valuation is essential since investors in the biotech sector rely on valuation to identify investment opportunities. Valuation enables investors to identify undervalued biotech companies with high growth potential, generate investment thesis, understand market trends, and make decisions that balance risk with potential returns.
From the perspective of an acquisition by a larger company, valuation helps determine the fair market value of the target biotech company, guiding negotiation and deal terms. Accurate valuation ensures that the acquiring company pays a price that reflects the company’s potential for future profits, assets, and liabilities, facilitating strategic decisions that align with long-term business goals and shareholder interests.
In essence, company valuation is an important process that informs decision-making, strategic planning, and investment strategies across the biotech industry. Whether for internal growth, investment, or acquisition, understanding and estimating a biotech company's value is indispensable for navigating the complexities and opportunities of the biotech sector.
Company Valuation Approaches: How to Value a Company?
There are two main approaches that can be used in company valuation: intrinsic and relative valuation. Each offers a distinct lens through which the financial worth of a company can be assessed, each with distinct advantages and disadvantages.
Intrinsic valuation involves calculating a company's value based on its fundamental financial characteristics. It's like assessing a home's worth based on its structure and land value, irrespective of neighboring property prices. An example is the Discounted Cash Flow (DCF) analysis. DCF analysis is a method to estimate a company's value by projecting its future cash flows and discounting them to their present value using a specified discount rate. This approach allows for a detailed valuation based on the company's ability to generate cash in the future, factoring in both growth prospects and risks. A major advantage of the DCF model is its thoroughness in evaluating a business's worth. However, a significant drawback of the model is its sensitivity to assumptions about the input values. Because many of the input values are estimates and based on assumptions, the model’s output can be only as good as the assumptions made.
Relative valuation compares a company's value to that of its peers in the industry, akin to evaluating a home's worth by comparing it to similar houses in the same neighborhood. Common methods include using ratios like Price to Earnings (P/E) or Price to Sales (P/S). This approach is practical and typically straightforward because it relies on readily available market data. A key advantage is its simplicity and ease of comparison across peers, making it useful for quick comparisons. However, its main drawback is that it assumes the market valuation of companies in the comparison set accurately captures these companies’ value, ignoring individual company nuances. This can lead to valuation errors if the market valuation of the companies in the comparison set is inaccurate.
These valuation approaches typically depend on tangible financial metrics, such as revenue, cash flows, or earnings, as their foundation. This reliance ensures that valuations are grounded in observable financial performance.
Why is Biotech Company Valuation Challenging?
Early stage biotech companies are at the cutting edge of healthcare as they develop the medicines and therapies of tomorrow. As their products are yet to be developed, enter the market, and generate profits, biotech companies have two main characteristics:
Biotech companies typically don’t generate revenue so valuation metrics based on generated revenue cannot be applied.
Biotech companies can be of incredible value even if they are years away from generating revenue.
The present value of a biotech company can be defined by all the profits that the company can potentially generate in the future, convoluted with the likelihood of the predicted profits materializing, and adjusting the value of these future profits to the present.
Thus, determining the value of a biotech company can be summarized as follows:
Estimate future profits from bringing the new medicines and therapies to the market.
Determine the likelihood that the biotech company will succeed in generating these future profits.
Discount the estimated future value back to present to determine present value.
Valuing biotech companies involves both intrinsic and comparables approaches, yet because biotech companies are often pre-profit and pre-sales, future profits and sales need to be estimated. Intrinsic valuation, like DCF, requires projected revenues and expenses, while comparables valuation typically requires estimating and comparing enterprise value and peak sales across similar companies and therapeutic areas. These estimates are based on assumptions about revenues and sales, which are intimately intertwined with the likelihood of these revenues and sales materializing in the future and the notion of risk in biotech.
Understanding Risk and Its Direct Relation to Value in Biotech
In the biotech sector, the concept of risk is fundamentally intertwined with the concept of value. This relationship is predicated on the understanding that the development of new medicines and therapies is an inherently uncertain process with scientific, regulatory, and market uncertainties. The development of a drug from conception to market involves multiple stages, each carrying its distinct set of risks and success rates. As a drug progresses through these development stages, the likelihood of its successful commercialization increases, thereby affecting the company's valuation.
Pre-revenue biotech companies, often founded based on promising initial findings, focus on drug development to advance these findings into clinical candidates. The development process often begins with preclinical studies, advances through multiple phases of clinical trials, and culminates in regulatory review before a new drug can be brought to market. At each stage of development, the drug faces tests of safety, efficacy, and regulatory compliance, with significant risk of failure at every step. The statistical probabilities of a drug moving from one phase to the next serve as a critical metric for assessing a biotech company's risk profile. For instance, estimates of the probability of success in clinical trial phases are as follows:
Phase I: 63%,
Phase II: 31%
Phase III: 59%
Regulatory review process: 85%.
Thus, the overall success rate for a drug to be approved by the FDA can be estimated as follows:
Probability Phase I x Probability Phase II x Probability Phase III x Regulatory Approval = Success Rate
63% x 31% x 59% x 85% = 9.6%
Therefore, the success rate associated with clinical trials and FDA-approval for a biotech company developing a new drug that is yet to enter clinical trials is about 9.6%. However, if the new drug developed by a biotech company has already successfully cleared Phase I trials, the success rate associated with remaining clinical trials and FDA-approval becomes:
Probability Phase II x Probability Phase III x Regulatory Approval = Success Rate
31% x 59% x 85% = 15.3%
Successful Phase II trials and entry in Phase III trials brings the success rate to:
Probability Phase III x Regulatory Approval = Success Rate
59% x 85% = 49.3%
The direct relationship between risk and value becomes evident when we consider how the likelihood of a drug's success impacts the biotech’s potential future value. Essentially, the value of a biotech company is a reflection of its potential to generate future profits from bringing new medicines and therapies to the market. As such, any reduction in risk—achieved for example by successfully advancing a drug through developmental stages—translates into an increase in the company's potential value. To a first approximation, the future value of a biotech company after approval of its new drug can be estimated by taking the product of the estimated future profits and the probability of FDA approval:
Future Profits x Probability FDA Approval = Future Value
Thus, to a first approximation, the estimated future value of a biotech company developing a drug that is expected to generate $10 B in future profits but is yet to enter clinical trials is:
$10 B x 9.6% = $0.96 B
The estimated future value of the same biotech company now having advanced its drug candidate to Phase II trials after successfully clearing Phase I trials becomes:
$10 B x 15.3% = $1.53 B
Thus, it is clear that the more development stages a drug candidate successfully clears, the lower the risk of failure, the higher the likelihood of success, and the higher the future value of the biotech company. To a first approximation, value in biotech is inversely proportional to risk, with risk reduction—derisking—generally increasing value:
Value ∝ 1/risk
This process of derisking can take various forms, including successfully completing clinical trials and obtaining regulatory approvals, enhancing the leadership team with experienced executives, and forming strategic partnerships, among others.
Investors and business analysts monitor these derisking events and use them as indicators of a biotech company’s maturation and the likelihood of bringing new medicines and therapies to the market. The progression through clinical trials, in particular, serves as a tangible demonstration of a drug's viability, significantly influencing investment decisions.
The intrinsic link between risk and value in the biotech industry underscores the importance of successfully clearing developmental stages in shaping biotech company valuation. By navigating the developmental pathway effectively and mitigating risks along the way, biotech companies can unlock significant value, attracting investment and driving the industry forward.
Conclusion
In conclusion, exploring company valuation is essential for understanding the financial worth of biotech companies, guiding decisions on investment, growth, and acquisition. This series begins by introducing company value and valuation alongside the concept of risk. Valuation methods, intrinsic and relative, rely on financial metrics and comparisons, and valuation of biotech companies poses unique challenges due to the pre-revenue nature of biotech companies and the uncertainties and risks associated with bringing their innovative therapies and medicines to the market. Estimating a biotech company’s value relies on making assumptions about future profits and success rates and making good assumptions requires a good understanding of the drug development process. As we delve deeper, we'll examine the main drivers of value in biotech, the various valuation methods and their advantages and limitations, and the principles of valuing biotech companies from an investing and acquisition perspective.
References
Mullard A. (2016). Parsing clinical success rates. Nature Reviews Drug Discovery.
Damodaran A. (2012) Investment Valuation: Tools and Techniques for Determining the Value of Any Asset, 3rd Edition. Wiley.
Chen J., Mansa J., Williams P. (2023). What is Valuation? Investopedia.
