Biotech Investing: Introduction to Discounted Cash Flow (DCF) Analysis for Biotech Valuation
In a Nutshell:
Biotech investing often involves valuing companies based on equity value, enterprise value, or intrinsic valuation methods like Discounted Cash Flow (DCF). These methods help investors assess the financial worth of biotech companies.
DCF analysis calculates the present value of future cash flows to determine a company’s value. It includes projecting revenue, forecasting costs, and discounting cash flows using a discount rate, typically the Weighted Average Cost of Capital (WACC).
DCF typically relies on historical data for revenue and expenses, but for pre-revenue biotech companies, these do not exist and must be forecasted. This reliance on estimates adds complexity and makes DCF more challenging for pre-revenue biotech companies.
To apply DCF to pre-revenue biotech companies, future revenue, expenses, and probabilities of clinical and regulatory success must be carefully estimated. This process involves numerous assumptions, making it prone to uncertainty and requiring careful sensitivity analysis to test how changes in key assumptions impact valuation.
Foundations of Biotech Valuation: From Market Capitalization to Intrinsic Analysis
The process of determining a company’s value–knowing what a company is worth in financial terms–is called company valuation. Company valuation is important for strategic investment planning and assessing potential acquisitions. If you are reading this, chances are you already understand why company valuation is important, but you can always learn more about biotech company valuation in my previous post.
The most straightforward approaches for estimating the value of a publicly traded biotech company are equity value (or market capitalization) and enterprise value (EV) approaches. Market capitalization (or market cap) reflects the total equity value of the company–the value of a company attributable to its shareholders–and is obtained by multiplying the current market share price by the total number of shares. Enterprise value incorporates debt and cash and is thus a more comprehensive representation of a company’s value. Enterprise value is calculated by adding the company’s current debt to its market cap and then subtracting its available cash.
Both market capitalization and enterprise value depend on the company's share price, which is determined by the broader stock market. This share price, quoted on the stock exchange, represents the consensus of what all market participants think about the company’s value, based largely on collective expectations for its future profits. However, this valuation reflects the market’s collective consensus judgment, which may not always align with an individual investor's perspective.
An individual investor might chose to conduct an independent valuation to assess whether the market's expectations are overly optimistic or pessimistic–whether the company is overvalued or undervalued by the market. This analysis enables an individual investor to identify potential opportunities or risks that the broader market might have overlooked, helping them make more informed investment decisions tailored to their own insights and expectations. Broadly, two types of analyses can help an investor independently assess valuation: intrinsic valuation and relative valuation.
Discounted Cash Flow (DCF) Analysis: the Basics
Discounted Cash Flow (DCF) is one of the most widely used methods to value a company and estimate its share price. The model calculates the present value of a company’s future free cash flows, adjusted for the time value of money, and can be used to calculate both the enterprise value and, subsequently, a share price for a company. The DCF analysis typically forecasts financial performance over a number of years into the future. Below is an overview of the main steps in calculating a company’s share price using a DCF valuation model:
1. Project Future Revenues. A company’s historical revenue data are typically used to forecast future revenues over a defined period (e.g., 5 years or 10 years). Assumptions about growth rates are typically based on economic trends, market conditions, and the company's competitive position among others.
2. Forecast Expenses. Historical data and trends are used to forecast the company’s expenses:
Research and development (R&D): Cost of developing the product.
Cost of goods sold (COGS): Cost of producing the product.
Selling, general, and administrative expenses (SG&A): Cost of selling the product and running the company.
Expenses = R&D + COGS + SG&A
3. Calculate Operating Income. Also known as Earnings Before Interest and Taxes (EBIT), operating income measures profitability from a company’s operations. EBIT is calculated by subtracting expenses from revenue:
EBIT = Revenue - Expenses
4. Calculate Cash Flow. Unlevered Free Cash Flow (UFCF) reflects the cash available to both equity and debt holders, focusing on the potential of the biotech company without being influenced by its financing structure and liabilities. UFCF is obtained by adjusting EBIT for taxes, capital expenditures (CAPEX), depreciation and amortization (D&A), and non-cash working capital (NCWC), but it does not account for debt and interest payments.
FCF = EBIT*(1-tax rate) – CAPEX – NCWC + D&A
5. Discount to Present Value. To account for the time value of money (a dollar today is worth more than a dollar in the future) a discount rate–typically the Weighted Average Cost of Capital (WACC)–is used to calculate the present value of each future cash flow. The discount rate reflects the risk and opportunity cost of investing in the company.
PV = (Cash flow)/(1+r)n
where n is the time period or year of the cash flow being discounted, and r is the discount rate (WACC).
WACC represents the average rate a company pays to its equity and debt holders, weighted by their respective contributions to the company’s capital structure. In essence, it reflects the cost of capital needed to finance the company. Learn more about WACC here.
6. Calculate Terminal Value. Terminal value estimates the value of a company at the end of the forecast period, representing all future cash flows beyond that point in perpetuity, discounted to their present value. In a DCF analysis, terminal value is commonly calculated using either the perpetual growth method or the multiples method. Learn more about these methods here.
7. Obtain the Present Value. The present value (PV) refers to the current worth of all projected cash flows during the forecasted period plus the discounted terminal value. Adding these values provides the enterprise value (EV).
EV = Discounted cash flows + Discounted terminal value
8. Determine Share Price. To calculate the share price, debt is subtracted and cash is added to the enterprise value to obtain the equity value. The equity value is divided by the number of shares to calculate the share price.
Equity value = EV + Cash – Debt
Share price = Equity value/Number of shares
The Discounted Cash Flow (DCF) method relies on assumptions
The DCF method is a quantitative tool that provides a precise estimate of a company's value by modeling future cash flows and discounting them to their present value. However, it is important to differentiate between precision and accuracy: while DCF can yield a highly precise number, the result may not be accurate due to its reliance on numerous assumptions. Key assumptions include revenue growth rates, expense trends, discount rates, and terminal value growth—all of which are inherently uncertain.
To address uncertainty in assumptions, a sensitivity analysis is typically performed. The analysis involves testing how changes in key assumptions impact the calculated share price. Thus, sensitivity analysis helps evaluate the model's robustness and identifies the variables with the greatest influence on the final valuation.
For pre-revenue biotech companies, performing a DCF calculation becomes even more challenging. In the next section, I will explain why this is the case and how we can approach biotech valuation using the DCF method.
Despite its widespread use, the DCF method has limitations. Its reliance on numerous assumptions, such as growth rates and discount rates, makes it sensitive to even minor changes in inputs. For biotech companies, where uncertainty around clinical trial outcomes and regulatory approvals is particularly high, DCF models can produce widely varying results. As a result, while DCF provides valuable insights, it probably should be used together with other valuation methods and a thorough understanding of the company’s context, the science behind the company’s new medicine or therapy, and the drug development process.
Discounted Cash Flow (DCF) Analysis of Pre-revenue Biotech Companies is Challenging
The products of biotech companies–the medicines and therapies of the future–are typically in the research and development stage and not yet commercialized. Therefore, biotech companies often do not generate revenue and historical revenue data are unavailable. Additionally, since biotech companies’ products are still in development, there are no historical costs for COGS and SG&A. As a consequence, revenue and expenses need to be estimated to perform a DCF analysis.
To use the DCF method to value a pre-revenue biotech company, the following steps are necessary:
Estimate future revenue from the biotech’s potential medicines and therapies.
Forecast expenses associated with developing, manufacturing, and selling these potential new products.
Adjust the unlevered free cash flow (UFCF) to account for the probability of the company’s success in generating future revenue.
Estimating Future Revenue. For simplicity, let’s assume that a biotech is developing a single drug for a single indication. This approach can easily be adapted to account for multiple drugs or therapies targeting multiple indications. Future revenue can be estimated using a revenue build approach, which requires determining the number of patients expected to use the new drug after it is commercialized and the price the drug. For a given forecast year, the revenue can be calculated as:
Revenue = Number of patients x Medicine price
Estimating the Number of patients. To estimate the number of patients expected to use the new drug, we need to consider:
Population with the target disease: identify the size of the population affected by the disease.
Fraction of the population paying for treatment: the most relevant are patients with insurance.
Fraction of patients adhering to the treatment: those who follow through with prescribed therapy.
For example, from the US population of about 345 million (as of 2024), about 0.1% (345000) have lung cancer. Of these, approximately 90% (310000) are insured, and about 90% (280000) are expected to adhere to a new cancer medication.
The above estimates can change over time due to population growth and shifts in disease incidence, which should be accounted for during the DCF forecast period.
Other factors influencing the number of patients include:
Relevant patient sub-populations based on demographics or contraindications.
The fraction of patients prescribed the drug versus competing therapies.
The frequency of prescriptions per patient annually.
For the DCF analysis, the price for a new drug can be estimated by referencing the prices of similar drugs already on the market.
Estimating the Expenses. To forecast the expenses, the costs of R&D, COGS, and SG&A must be estimated.
COGS and SG&A costs are typically expressed as percentage of revenue (or sales) over the DCF forecast period.
R&D costs and duration period depend on the development stage (pre-clinical or clinical) of the drug. Clinical trial costs vary significantly by phase and can be estimated based on the cost and duration of the clinical studies for similar drugs.
Probability-Adjusting the Unlevered Free Cash Flow. Once revenue and expenses are estimated, the UFCF can be calculated. For biotech companies, this value must be adjusted for the probability of the drug successfully passing clinical trials and receiving FDA approval. Each forecast year’s UFCF during clinical development should be weighted by the likelihood of success for the corresponding clinical phase. Further, UFCFs for forecast years following FDA approval should also be weighted by a probability of success, to account for the possibility that the new drug in development might never be approved and commercialized. These adjustments ensure a more realistic valuation by incorporating the inherent risks associated with drug development.
Disclaimer: This article provides general information about valuation of 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.
