Biotech valuation multiples: how to value a biotech company?

Anyone investing in biotech stocks will be faced with the challenge of finding the right price for a company’s shares. Experts share their most reliable valuation methods. 

Unfortunately, there is no single formula that can condense the multiple parameters influencing a biotech stock — market potential, cash burn rate, the management team, business strategy, intellectual property, and even unpredictable events such as a global pandemic. Still, the information gathered by investors can be translated into reasonable assumptions that can then be used to get a good idea of the worth of a particular investment in a biotech stock.

Biotech valuation: the importance of knowledge

“Particularly for the valuation of early-stage projects, technical knowledge is important,” noted Peter Abelin, Life Science Senior Consultant at the Danish valuation consultancy firm Xplico. Knowing well the potential of the technology being developed and how it compares to what is on the market or under development by competitors is a good first step to determining how likely a product is to make it to the market — and take a big enough share of it. 

Investing in early-stage companies is risky; during the years it takes to get a drug through research, clinical trials, and regulatory review, the drug candidate can fail at any time. The earlier an investor gets in, the more chances a particular product candidate will not make it through to commercialization. But if the product makes it to market, the potential return will be much higher. Generally, the closer to the sales stage, the lower the risk for the investor, but also the lower the potential financial returns. 

For a biotech company, there are a number of factors that go into setting its price, according to Jan Van den Berghe, founder of the early-stage venture capital (VC) investor Novalis. 

“We will always check how much money has gone in, how many grants have gone in, how much customer money has come in, how much of your own time has come in and at what value, what is your patent work, how long have you been going – in that period, have you created value, or destroyed value, or just sat around doing nothing,” said Van den Berghe. “That’s one exercise we always do.”

And, of course, there are metrics to determine how well — or not so well — a company is doing. Investors tend to look at the internal rate of return (IRR) and the return on investment (ROI), both ways to measure how profitable an investment is. 

“You could make a graph from the start of a company at cost price, where the value of the company goes. It goes up because obviously, you spend money, you buy stuff, you’ve got a patent. And so your cost line goes up, but your value line goes up steeper, and that gives a wedge. It goes bigger and bigger and bigger. And the thing is, as an investor, along the way, you constantly have to jump between the bottom (cost line) and the top (value line) because you want to go for the top, but you have to protect yourself against the bottom,” Van den Berghe.

Therapeutics vs. non-therapeutic biotechs: how do their valuations differ?

However, there are differences between how a therapeutics company is valued versus how diagnostics, medtech, and biotech manufacturing companies are valued, the latter being Van den Berghe’s area of investments.

For instance, a therapeutics company “goes after a very targeted local monopoly or local oligopoly,” explained Van den Berghe. For these companies, it doesn’t necessarily matter if the team changes along the research and development (R&D) stage — at least not to the extent that it affects non-therapeutic biotechs. 

“The team (in non-therapeutics) typically stays the same. Those who found it are those who run it until it gets an M&A, whereas in a therapeutic, it’s too long; it’s 10 years. Typically it’s not the founder, certainly not the scientific founder who runs it all the way to M&A or IPO. So that will change,” said Van den Berghe. “That will also mean that, in terms of stock options for the new management team, that changes as well.”

If the team isn’t strong in the case of non-therapeutic biotechs and life science companies, it isn’t a promising sign for investors.

Van den Berghe said: “In therapeutics, it’s different. If one of the guys doesn’t work, you’ve got a 10-year trajectory; somebody else will do it. In our case, it’s typically different. You do want the original team to stick together and to work, and therefore, also to be motivated.”

Moreover, therapeutics companies rely on a number of funding rounds to survive. These companies “burn cash” all the way, according to Van den Berghe. 

“Chance of having any revenues along the way is very small or insignificant towards the cost of the operation,” said Van den Berghe.

Whereas non-therapeutic biotechs tend to have fewer funding rounds as they make money from customers and grants. “That means we can afford to start with a lower stake to still get a decent return,” Van den Berghe said. 

Exit strategies may also differ. While therapeutics companies may opt for initial public offerings as well as M&As to provide investors a return on their investment, non-therapeutic biotechs herd mainly towards M&As.

“Just look at 20 years of IPOs, of anything in life sciences,” Van den Berghe said. “It’s a battlefield. Yes, you can be very lucky and do very well. Yes, you can go on the stock market and then get bought a year later at a premium. But for those stories, you’ve got five more stories on the other side.”

Go with tradition: the net present value

The most traditional way of calculating the value of a company is by determining its net present value, or discounted cash flow. This basically consists of determining the future cash flow of a company after a certain period of time, and discounting that value to take into account the risk that the company will not be able to make it to the stage where those sales become a reality. 

To estimate the future cash flow, it is necessary to forecast the sales of a drug based on the expected market share and its price. The amount that is forecasted to be spent on running the company’s operations is then subtracted from the projected earnings. In case the plan is to license the drug to a pharma company, the revenues will only be a percentage of sales, but the operating costs will also be significantly reduced.

Discount is a key concept in biotech valuation. In financial jargon, it refers to determining the present value of a payment that is to be received in the future. In other words, it estimates the current value of a business based on its expected future cash flow.

Generally, an investor is willing to pay less when the risk is higher, so bigger risks come along with higher discount rates. The more mature the company, the lower the discount.

There is no unique way to calculate a discount rate, but it is mostly based on the company’s cost of capital. That is, the cost of the equity and debt needed for the company to complete its goals and make revenues that are higher than what was originally spent.

Discount rates in the pharma and biotech industries can vary a lot. For early-stage projects, the discount rate can reach up to 50%, reflecting the small chance to become a profitable business. As a drug reaches late-stage clinical trials, the discount gets closer to 20%. And for big, stable pharma companies, the discount rate is often between 10 and 15%. 

It should be noted that the fact that biotech valuation uses numbers does not mean it is a science. Some analysts caution about the subjective assumptions that are implicit in some valuation estimations, starting from calculating the discount rate. In fact, Van den Berghe deems it an ‘art’ rather than a science.

Calculating the net present value has been the usual procedure for biotech stock valuation for years, mainly due to its simplicity. However, it often only looks at the best-case scenario, in some cases relying on forecasts of cash flows that do not exist yet and on optimist predictions of R&D costs.

Dig into the detail: the risk-adjusted net present value

In the face of the limitations of calculating the net present value of a biotech company, the current standard valuation method in the drug development industry is the risk-adjusted net present value (rNPV). This method takes into account the probability that the predictions on future cash flow will not occur. 

“The risk-adjusted net present value is quite easy and quick to implement, also because it is understood by everybody in the financial markets,” said Damien Choplain, Senior Healthcare Equity Analyst at European financial service Oddo BHF. “In my opinion, the best option to evaluate a biotech or a drug is to build a robust and detailed rNPV model and validate each top-line assumption with key opinion leaders.”

Projects with significant uncertainty regarding their success, such as drugs, medical devices, and diagnostics, require careful consideration of risk at multiple points in the project’s lifecycle. To perform the risk adjustment, it is possible to use historical information of the success rate of similar products in the industry at different stages of development.

“Although there is probably not a better biotech stock valuation metric than common sense and experience, rNPV is a nice way of calculating an order of magnitude for a mid-to late-stage project,” said Jan de Kerpel, Managing Director of Life Sciences & Healthcare at the Dutch bank Kempen Corporate Finance. However, “early clinical or preclinical (stages) are not well served by this technique as certain parameters can have a massive impact on the future value.”

A key advantage of the rNPV method is that it can take into account the fact that the risk of a product candidate being developed by a biotech company is always linked to discrete milestone events, such as the successful completion of clinical trials or the process of obtaining regulatory approval.

“By spreading probabilities over more variables you get a better sense of what determines success and what creates value,” Abelin pointed out. That can include other intangible factors, such as “comparisons with what investors have been willing to pay, or looking at which development step creates the most value, such as when they strike a deal.”

“We also check the relevance of the outcome by comparing it with the market value of listed companies and deals struck by similar companies. We use a more or less standardized discount rate of 10-15%. Standardization in itself, with a real-life check, is valuable. Several others would use the same numbers. What something is worth is the result of value creation paired with a documented market interest in the product,” Abelin concluded.

Searching for more accurate valuation methods 

Another valuation method is the real options method, which is used to analyze the consequences of possible decisions. For example, a company contemplating the option to expand or the option to abandon a project. Another is the Monte Carlo method, a simulation tool for considering all possible combinations of events, and quite popular in financial circles. However not all analysts in the biotech sector like it.

“In my view, Monte Carlo is useless in the context of biotech, for publicly listed biotech companies at least. Keep in mind that a target price is ‘directional’ at least for small- and mid-cap biotech,” Choplain warned. “It is almost impossible to know which probability distribution you should apply to your different parameters. I used this method only once in the context of a company acquisition.”

The demand for more accurate valuations will continue to grow in the biotech industry, particularly for methods that consider flexibility and that can properly evaluate the commercialization stage too.

The latest generation of biotech valuation models is supported by software to run thousands of simulations, creating variations for all the inputs that the analyst might want to include, such as R&D costs or a product’s potential market share. 

“Valuation assessment will become more sophisticated and more granular, hence biotech valuation will have to combine scientific and clinical expertise and go-to-market and commercial expertise,” said de Kerpel. “All the technicalities of a small-mid cap public company that is often in need of cash has to be taken into account.” 

While there is no guarantee, supporting an evaluation with numerical calculations may help to develop a much clearer picture of a stock’s potential future. Usually, this becomes easier the more advanced the pipeline is, as there is more data available to support a prediction.

In this context, it is important to consider how valuable the technology a company is developing will be in the future. Over time, a biotech’s stock can be impacted, among other factors, by patent protection, competitors, technological changes, government regulations, currency exchange rates, or even broader trends such as economic and political crises. 

De Kerpel said: “It is important to make an assessment of the potential of a product: commercial, competitors, risk to market, interest from a big player, etc. and build from there. Trust in management, trading liquidity, near-term newsflow, backup plans, financial position, and trading of peers, are very important to anticipate trading movements.”