Biotech Company Valuation: The Comparable Companies (Comps) Approach
In a Nutshell
Analyzing companies for investing or acquisition often requires understanding valuation through equity value, enterprise value, or methods like Discounted Cash Flow (DCF) and Comparable Companies (Comps) approaches.
The Comps method benchmarks a target company's value against similar companies using market-derived multiples such as enterprise value (EV)/Revenue or market capitalization/sales.
For pre-revenue biotech companies, the absence of financial data like revenue or sales can be addressed using alternative metrics, such as EV-to-Clinical Stage or EV-to-Research Pipeline.
Revenue-based multiples require forecasting future revenue or sales, similar to DCF analysis, but focus on top-line estimates, making it a simpler yet insightful valuation method.
In the Comps approach, the enterprise value estimated using comparable companies' metrics (Comps-derived EV) is compared with the market-derived enterprise value (calculated using market cap, cash, and debt) to determine if a company is overvalued or undervalued by the market.
While Comps provide quick and market-driven insights, careful selection of comparable companies is crucial, especially in biotech, where therapeutic area, development stage, and market trends significantly impact valuation.
Introduction to Comparable Companies (Comps) for Company Valuation
Company valuation is the process of determining a company’s value–knowing what a company is worth financially. If you are reading this post, you are likely aware that company valuation is important when considering investments or acquisitions, and I encourage you to also read my previous posts that lay some of the foundations of biotech valuation.
The financial worth of a company is often expressed through equity value (or market capitalization) and enterprise value (EV). Equity value represents the value attributable to shareholders (number of shares * share price), while enterprise value offers a more complete view by also taking into account a company’s debt and cash. Equity value and enterprise value reflect the stock market sentiment about the company’s potential to generate profits. Both market capitalization and enterprise value depend on the company's share price, which is determined by the broader stock market.
An individual 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. In a previous post, we explored Discounted Cash Flow (DCF) analysis, an intrinsic valuation approach used to estimate a company’s future cash flows and adjust these cash flows to reflect their present value (to account for the time value of money). This post shifts the focus to relative valuation and we will overview the Comparable Companies (Comps) approach. In short, the Comps approach estimates a company’s value by benchmarking it against similar companies.
Comparable companies (Comps) Approach: Overview
The Comps approach involves identifying a set of comparable companies, gathering their financial data, and applying relevant valuation multiples to the target company. The process can be broken into three main steps:
Identify Comparable Companies. Companies of similar size, business model, stage of development, and/or industry sector are identified and it is expected that similar companies have similar valuations. For biotech companies, comparable companies might focus on similar indications, develop similar therapeutic modalities, and/or be at similar clinical development stages.
Choose Valuation Multiples. The most commonly used valuation multiples include:
Price-to-Earnings (P/E). P/E measures the consensus price that investors are willing to pay per dollar of a company’s earnings. A higher P/E ratio often indicates high growth expectations, while a lower ratio may suggest undervaluation or lower growth expectations.
Enterprise Value-to-EBITDA (EV/EBITDA). EV/EBITDA compares a company’s enterprise value to its operating earnings before accounting for financing costs, taxes, and non-cash expenses. Higher EV/EBITDA can indicate expectations for higher operational efficiency.
Price-to-Sales (P/S). P/S measures the consensus price that investors are willing to pay per dollar of sales. This metric can be used for early-stage companies and higher P/S are typically indicative of expectations for sales growth.
Apply Valuation Multiples. Once relevant metrics are calculated for the comparable companies group, averages or medians are applied to the target company’s financial data to estimate its value.
Example: Comparing Comps-Derived and Market-Derived Enterprise Value (EV)
We aim to estimate the enterprise value of Company X via the Comps approach. To this end, we identified Companies, A, B, and C as comparable companies. These companies were selected based on their similarity with Company X in terms of targeting the same indication via the same therapeutic modalities and being at the same development stage.
Step 1: Calculate the Comps-Derived Enterprise Value
The enterprise value and revenues for the comparable companies were obtained from their financial statements. The calculated EV/Revenue multiples for each company together with the average multiple, are shown below.
Company A: Enterprise value = $520 M; Revenue = $50 M; EV/Revenue = 10.4
Company B: Enterprise value = $680 M; Revenue = $58 M; EV/Revenue = 11.7
Company C: Enterprise value = $490 M; Revenue = $60 M; EV/Revenue = 8.2
Average EV/Revenue = (10.4 + 11.7 + 8.2)/3 = 10.1
Using the average EV/Revenue multiple of 10.1, we calculate Company X’s enterprise value based on its revenue of $48 M that we found from its financial statements:
Comps-derived enterprise value = Revenue * Average EV/Revenue
Comps-derived enterprise value = 48 * 10.1 = $485 M
Step 2: Calculate Market-Derived Enterprise Value
To determine if Company X is overvalued or undervalued by the market, we need to compare the Comps-derived EV to the market-derived EV.
We calculate the market-derived EV by using publicly-available data:
Shares Outstanding: 40M
Share Price: $10
Cash Reserves: $50 M
Debt: $30 M
Of note: the share price used should be recent and reflect market conditions at the time of valuation.
Market-derived EV = (shares outstanding * share price) – Cash + Debt
Market-derived EV = (40 * 10) – 50 + 30 = $380 M
Step 3: Compare the Comps-derived and market-derived EVs
Since the market-derived EV is lower than the Comps-derived EV, we conclude that Company X is undervalued by the market which could indicate that the market as a whole has relatively low expectations about Company X’s future performance. This discrepancy may indicate an opportunity for investment, provided other factors such as pipeline potential, competitive positioning, and leadership align with investor expectations.
Advantages of the Comps Approach
Market-Driven: The comps approach reflects market sentiment, providing a snapshot of how the broader market values similar companies. This immediacy is invaluable for making timely investment decisions.
Ease of Use: Compared to more complex models like DCF, Comps are straightforward to calculate and interpret, requiring less time.
Benchmarking: Comps offer a quick way to compare a company’s valuation against its peers. This benchmarking helps identify whether a company is overvalued or undervalued relative to its industry.
Limitations of the Comps Approach
Reliance on Peer Selection: The validity of the Comps analysis relies heavily on the appropriateness of the selected comparable companies group and thus require careful selection of peers. Poorly chosen peers can lead to misleading valuations.
Limited Peer Universe in Biotech: In niche therapeutic areas, finding a sufficient number of truly comparable companies can be difficult. Fields like gene therapy or rare diseases often have only a handful of peers, making reliable benchmarking more challenging.
Market Dependency: Comps are clearly relying on the broader market sentiment and current market trends. The broader market could be misjudging an industry or a set of companies and periods of unrealistic optimism or pessimism could skew comparable companies’ valuations and thus lead to erroneous company valuation.
Simplistic View: While easy to apply, the Comps approach may oversimplify a company’s unique characteristics, overlooking certain drivers of value like leadership experience, scientific and clinical expertise, or intellectual property.
Discounted Cash Flow (DCF) vs Comparable Companies (Comps): Balancing Precision and Practicality
When valuing companies, DCF and Comps are among the most widely used approaches, each with its strengths and trade-offs.
DCF offers high precision by explicitly modeling future cash flows, requiring detailed assumptions such as market size, penetration rates, pricing, and costs among others. This level of granularity makes DCF a powerful tool for scenario-based analysis but also more time- and effort-intensive. Comps, on the other hand, provides a quicker alternative by relying on current market and financial data in the form of market-derived multiples, embedding assumptions about key parameters directly into the multiples. While Comps is faster and less complex, it sacrifices some precision for simplicity.
An important distinction lies between precision and accuracy. Precision reflects the level of detail in a valuation (for example, $3.3 B is more precise that $3 B), while accuracy measures how close the valuation is to actual outcomes—something that only the future can reveal. A very precise DCF model may still be inaccurate if its assumptions are flawed, while a less precise Comps-based valuation might align better with market sentiment.
In practice, DCF and Comps can complement each other. DCF is ideal when detailed data and time are available, particularly for later-stage companies, while Comps is better suited for quick, early-stage valuations or benchmarking. Combining both methods often provides the most balanced perspective, blending intrinsic value with market realities.
Using Comps for Pre-Revenue Biotech Companies
Pre-revenue biotech companies are typically years away from bringing their innovative therapies to market and generating any sales or revenue. Therefore, a major challenge in applying the Comps approach to pre-revenue biotech companies is the absence of sales or revenue data. To address this, the Comps approach can be applied in two different ways:
Simplified Comps Valuation Using Non-Revenue/Sales Metrics
This approach relies on benchmarking a company’s enterprise value or market capitalization against non-revenue metrics that reflect the company’s stage of development or potential. Examples include:
EV-to-Clinical Stage. Compares a company’s enterprise value to the stage of its lead clinical program (e.g., preclinical, Phase 1, Phase 2, or Phase 3). For example, companies with Phase 2 assets are expected to have higher valuations than those yet to enter clinical trials.
EV-to-Research Pipeline. Benchmarks valuation against the breadth and depth of a company's drug pipeline, considering the number of programs, diversity of indications, or unique modalities. For example, companies targeting multiple indications tend to have higher valuations than those targeting a single indication.
This method is less detailed than revenue-based Comps and is particularly useful for early-stage biotech companies with significant uncertainty around their ability to commercialize products.
Revenue- or Sales-based Multiples
Comp valuation can incorporate revenue-based multiples like EV/Revenue or EV/Peak Revenue. While this approach adds complexity–revenues for pre-revenue companies need to be forecasted–it provides a more detailed framework to estimate a biotech's valuation. Here's one way to do it:
Revenue or Sales Forecast. This involves projecting the future revenue, peak revenue, or sales for the company. It’s similar to what is done in a DCF analysis–assumptions are made about patient population, market penetration, and pricing among others–but focuses solely on top-line estimates rather than detailed cash flow modeling.
Applying Multiples. Once revenue, peak revenue, or sales are estimated, comparable companies’ EV/Revenue, EV/Peak Revenue, or Market cap/Sales multiples are used as a benchmark to obtain a valuation.
Revenue Estimation for Comps Is Simpler Than for DCF
Although estimating revenue or peak revenue for Comps involves some of the same steps as DCF, it is generally less complex:
Top-Line Metrics. Unlike DCF, which requires forecasting detailed expenses, cash flows, and discount rates, Comps focus solely on estimating revenue, peak revenue, or sales making the process simpler.
Market-Based Benchmarks. Comps rely on observed market multiples from similar companies, reducing the need to model intrinsic assumptions like capital expenditures or working capital changes.
Simplified Assumptions. Revenue or sales estimation for Comps often uses straightforward assumptions about market size, penetration, and pricing without diving into the granular details of financial operations.
Tips for Selecting Comparable companies
Selecting the right set of comparable companies is clearly essential to ensuring a reliable Comps analysis. Here are some suggestions to guide the process:
Therapeutic area. Choose companies developing drugs or therapies in the same or closely related therapeutic areas. For example, a company developing oncology treatments is best compared to other oncology-focused companies.
Development stage. Select comparable companies that are at the same clinical development stage. A company with a Phase 2 asset is best compared to other Phase 2 companies, as their risk profiles and valuation drivers are more aligned.
Company size. Include companies with similar market capitalizations or enterprise values. This makes the financial metrics and market sentiment more comparable. Consider removing outliers from the comparables group that could distort multiples’ averages or medians, such as companies with unusually high or low valuation multiples.
Therapeutic modality. Compare companies developing similar therapeutic modalities or drug discovery platforms. For example, a company developing small molecule therapies may not be directly comparable to one focused on gene editing.
Geographic considerations. Take into account that companies operating in the same regions often face similar regulatory environments, competitive dynamics, and reimbursement challenges.
Conclusion
The comparable companies (Comps) approach is a practical and popular method for biotech valuation. While it offers simplicity and market-driven insights, it is not without its challenges, particularly in selecting the comparable companies group. Combining Comps with intrinsic valuation methods like Discounted Cash Flow (DCF) can provide a more holistic view, balancing short-term market sentiment with long-term potential. By understanding the strengths, limitations, and nuances of comps, investors can make more informed decisions in the dynamic world of biotech investing.
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.
