FWIW: I do not lurk here often, and never contribute. But I published this in the April issue of NI, and decided to post it here as a comment on the differentiation of the dot.com phenomenon and biotech, a differentiation that I do not consider 'disingenuous'. It is not presented as anything novel in the biovaluation realm per se, there are numerous contributors on this Board who make far more sophisticated attempts at the valuation process--and the thread is thus credited at the end.
"The Problem of Biotech Valuation: For three years we were spared the valuation problem. It was very straightforward: we could repeat ad nauseum the familar refrain that the neuro sector was grossly undervalued, as was biotechnology/biopharm in general. But then this familiar terrain became radically transformed, as investors turned once more to biotech as another repository of potentially dazzling returns. The NI Index was at 110.00 in May 1999, and reached 354.16 at the end of February 2000, an increase of 222% in 10 months. One month later, it had plummeted 32% .This vertiginous rollercoaster of a quarter begs the question: how does one arrive at a reasonable valuation for this sector and the companies in it?
The question touches upon the near-cliched dichotomy of the 'New Economy' and the 'Old Economy.' Is the 'New Economy'truly new, or is it just the Old Economy, thirty minutes post-Viagra? As has been written about in the financial press so often, the concept of the New Economy involves such sectors as Internet companies, telecommunications firms, and more recently, biotechnology. The designation 'New' in some ways is a way of rationalizing the fact that the valuations of companies in these areas have not behaved according to the traditional rules of the stock market. They have been selling at levels hundreds of times revenues, let alone earnings. Indeed in an area generally sans profits, P/E ratios have been treated like archaeological artifacts.
The mindless momentum players who look at these stocks as just another commodity to be traded as rapidly as possible have certainly contributed to the scale of fluctuations in perceived market value. But that is not the whole story. Biotech companies have been swept into this optimistic view of unlimited growth partially because they do offer the prospect of expanding human control into domains previously untouched. It is no wonder that those firms who promise to decode the human genetic blueprint in the service of altering it have so fired the imagination of the public, because it allows us the prospect of becoming the architects of our own reCreation. And just as the fantasy of being ?wired? into an infinite array of information resources and communication options has driven the high tech boom, so too does the fantasy of rewriting our own genetic destinies feed into the human wish for omnipotence (and the fantasy of immortality).
But that is a wish doomed to go unfulfilled. As more realistic (albeit still impressive) aspirations replace it, we expect that the New Economy will look somewhat more like the old one. And in terms of the companies that are developing biomedical treatments, these aspirations look downright mainstream. Biopharmaceutical goals for the next ten years are to provide useful products for patient populations which exist and are expanding. The millions of patients suffering from Alzheimer's, Parkinson's, stroke, and all tbe other nervous system disorders, constitute existing markets waiting for their first treatment option, or a better one. This is far different from the Internet/e.commerce companies, many of whom are seeking to create demand where none existed before. Much of the New Economy hype revolves around the creation of new markets, new needs. But the e-commerce industry is already shaking out, as people question whether they truly need Internet food-shopping and pet supplies. The New Economy has pushed the speculative envelope regarding what people really want, and will pay for. Even when such a demand is at least temporarily created, the barrier to competition is virtually nil.
It is a very different scenario for biotech/biopharm companies. They have no need to create demand, there are millions of patients already out there and suffering. Patent protection and marketing exclusivity provide these companies with the prospect of territorial dominance in defined but as yet untapped markets. Thus we consider biopharm/biotech companies to to be hybrids. They may be New Economy in terms of their volatility and entrepeneurship, but their prospects are best evaluated with Old Economy tools, to the extent to which they can be realistically assessed at all. The fundamental Old Economy tool that we emphasize is that of projected earnings, discounted for the time to fruition. After all, when these companies make the leap from R&D boutiques to revenue-generators, they tend to then be appraised in a much more traditional way, sometimes without even acknowledging their distinctly radical prospects for revenue growth. P/E?s for these firms should be akin to those accorded other components of the New Economy, because earnings growth for the company producing a Better Treatment for Alzheimer?s (or other similarly scaled market) will be astronomical, and one can justifiably anticipate 50-100% sales growth per year for several years. We have tended in the past to be conservative with our P/E model, topping out at 35-40, but with even monolithic high tech firms now being accorded P/E ratios of 60-100, there is no valid reason not to extend that to biopharm, other than a fear of overconfidence. Such neuro companies as Cephalon, Gliatech, Guilford, Pharmos, and Shire, who have marketed products, plus pipelines which has reached human trials, are most appropriate for this model. One can integrate current sales and projected growth, together with the anticipated value of programs already in human trials.
Firms without marketed products, but who have the possibility of reaching the market in the next three years, such as Neurocrine Biosciences, Titan, Neurobiological Technologies, and NeoTherapeutics, can be stretched into this valuation paradigm, but with difficulty, because the further out you go timewise, the less accuracy is assumed. Our practice is to break down their R&D programs by therapeutic target, assess the scale of competition within each target, and then conservatively assume that only one or two of those targets are going to be successfully achieved. This can represent something of a juggling act, because for a small company, being the first (or only) entry into a small market can be just as valuable as producing a slightly improved drug in a crowded large market.
But when a company has not even reached human trials, our bias is that for long-range prospects, such as CytoTherapeutics, the calculation of revenues from 2006 or further out is not worth the disk space it takes up. This does not mean such companies have no value, but frankly, we believe the value of their science and patent positions cannot meaningfully be measured without proof of their scientific principle, which ultimately requires validation in humans. One can certainly attribute some putative value to cash positions and collaborations, but ultimately, that is a relatively minor component, other than to the degree to which these fiscal factors provide them with longevity and collaborative flexibility. Ultimately the value of biopharm companies lies solely in the products that they will bring to the biomedical field, or that they (if a 'toolkit' company) help bring to such fruition. Investments in these firms are at best, educated wagers, and the value is what the market will bear at the time.
But as we contemplate these well-placed wagers, the use of the term is not intended to denigrate the choice. There are few if any investment options that offer anything near the potential of these untapped and yet defined markets, markets that will only expand with time and the availability of useful treatments. It is the massive leverage achievable by investing at relatively low cost in these companies that justifies that choice, because the potential payoffs are absolutely enormous. It is this potential growth that justifies investments which are impossible to evaluate with traditional yardsticks. The following table is intended as a sample, and a reminder of this scale:(the text was here accompanied by the usual table of billion dollar market/disorders and the current billion dollar drugs addressing them, or lack thereof).
Fine-tuning revenue projections for distant timeframes is an obsessive's task, but any company that successfully enters any of those markets (and there are numerous others, such as Parkinson's, ADHD, and TBI) will be worth a great deal more than it is today. Far more important than the number of patents, revenue per employee, percentage of R&D to total expenditures, and the other arcana of valuation, will be having the right patent, the right employees, and the right and/or lucky research and development. And those factors begin to reliably express themselves in the design, timing, and results of human trials, which is when one can start to provide valuations that are worth the time spent in their calculation. (For our readers who are more obsessionally inclined than we are, there is an Internet discussion thread on 'Silicon Investor' which is exclusively devoted to 'Biotech Valuation,' and is thusly named. The contributors are highly knowledgable and worth reading, if this is an area of interest)."
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