A Complete Guide to Pharma and Biotech Valuation and Best Practices

Properly valuing drug and biotechnology assets is essential for pharmaceutical enterprises, biotech companies, investors, and other healthcare stakeholders. Valuation provides vital insights to inform high-impact decisions including clinical trial continuation, new product evaluation, licensing transactions, mergers and acquisitions, R&D investment prioritization, and strategic planning. For drug developers, biotech firms, investors, and entrepreneurs, expertise in valuation methodologies aligned with the sector’s idiosyncrasies confers advantages in quantifying addressable market potential, determining asset or opportunity value, investment value, asset pricing for deals, and so on.

As an expert provider of valuation services for the pharmaceutical and biotechnology sector, we discuss several valuation methods used in the sector, their application in various scenarios, best practices for conducting the valuation for pharma and biotech assets and understanding key value drivers that are specific to the sector such as clinical trials, attrition rate, regulatory milestones, patent expiry, market exclusivity, etc. so that those with interest in the biopharma assets and business can make informed and superior decisions.

Key Methods for Pharmaceutical and Biotech Valuation

Several core valuation techniques are commonly used to appraise biopharma assets and are underpinned by financial modeling:

1. Discounted Cash Flow Analysis: Discounted cash flow (DCF) analysis projects future cash flows that are discounted to present value using a discount rate appropriate for the opportunity risk. DCF is a foundational model used to value commercial stage drug firms. It is also known as the NPV (Net Present Value) analysis.
2. Risk-Adjusted Net Present Value: For clinical stage biotech assets, risk-adjusted NPV (rNPV) incorporates the probability of success into projections to account for development risk. This captures the high failure rates in biotech.
3. Real Options Valuation: Real options models flexibility to alter projects based on technical results and clinical data. This reflects the dynamics of pharma R&D better than static DCF.
4. Comparable Valuation: Comparables analysis benchmarks value based on trading and transaction multiples of similar public companies and precedent deals. This complements DCF approaches.

Each methodology has pros and cons for different pharmaceutical and biotech valuation purposes. Triangulating value using multiple methods provides the most accurate asset and company valuations and is the prevalent practice in the biopharma industry.

Discounted Cash Flow Analysis

Risk-adjusted Net Present Value (rNPV)

Risk-adjusted NPV (rNPV) enhances standard DCF analysis by adjusting cash flow projections for the probability of success (POS), i.e., adjusting for the probability of successfully advancing through clinical trials and regulatory approval (PTRS) or conversely, attrition rate. As a result, this method is also referred to as the expected net present value (eNPV) method. Among the various early-stage biotech valuation methods, the rNPV method is the most appropriate. This method is suited for valuing:

• Preclinical and clinical stage biotech assets
• Novel pharma and biotech drugs undergoing development
• Other life sciences assets that undergo phased development

The mechanics of rNPV involve:

• Estimating clinical trial and approval probabilities
• Adjusting cash flow projections for risk using these probabilities
• Discounting risk-adjusted cash flows to present value
• Summing risk-adjusted cash flows to derive rNPV

This captures the risks inherent in biotech drug development. rNPV provides a more accurate asset valuation than basic DCF as it enables conducting pharma and biotech valuation based on the stage (preclinical, Phase 1-3) of development of assets.

Real Options for Valuation

Real options valuation incorporates management’s flexibility to alter projects based on emerging results, the term ‘real options‘ is used to differentiate from financial options. This dynamic approach is beneficial for valuing pharmaceutical R&D pipelines, where companies make ongoing go/no-go decisions on compounds as development progresses through stages. Real options pharma valuation models:

• Decision options to expand, pause, or terminate projects
• Impact of outcomes at development milestones
• Managerial flexibility lacking in static DCF

By capturing decision optionality, real options valuation can provide a more accurate depiction of pharma and biotech asset value versus traditional NPV or rNPV approaches.

Comparable Valuation

All of the aforementioned methods rely on future cash flow and thus entail a certain degree of uncertainty. The comparable valuation method is based on the principle of determining value by considering what someone has previously paid for a similar asset. Pharma and biotech comparable company analysis provides a market-based valuation approach by comparing the target asset to similar companies and deals. The steps include:

• Identifying comparable publicly traded firms or precedent transactions
• Deriving price multiples like P/E, revenue, EBITDA multiples
• Applying multiples to the target asset’s metrics
• Making adjustments for differences between comparables and the subject asset

While straightforward in theory, finding perfect “comps” can be challenging. Appropriate comparable companies selection and adjustment are key for accuracy. This market-based methodology complements DCF analysis. However, there are limitations to comparable valuation methodology. Identical assets are hard to find, and precedent deal data can be dated. For pharmaceutical licensing deals involving single assets, finding public comps can be difficult. In these cases, DCF-based analysis like rNPV is more applicable.

Pharma and Biotech Valuation Multiples

Comparable valuations result in valuation multiples, and they need to be applied to the biopharma asset whose value one is seeking to compute. There are several pitfalls to using valuation multiples:

• Most valuation multiples come from publicly listed pharma and biotech companies and often include premiums and discounts from transactions and trading respectively that don’t apply to private biotech companies.
• Biotech valuation multiples use historical data, reflecting past value rather than future value. A company with a great past but bleak prospects would have an inflated multiple.
• Pre-revenue biotechs in particular get undervalued by revenue-based multiples like price-to-sales (P/S) and enterprise value-to-revenue (EV/R).
• For licensing deals, only upfront payments or headline values are public while deal terms are not disclosed. In such scenarios, valuation multiples lose their utility.
• Accounting differences between GAAP, IFRS and standards across countries distort valuation multiples.

Taking these limitations into account, conducting an rNPV valuation grounded in biotech fundamentals is a more suitable approach while valuation multiples (if available and appropriate) serve as both, a guiding tool and a means for sanity checking.

Sum-of-the-Parts Valuation

The sum-of-the-parts (SOTP) valuation approach is commonly used for biotech companies with multiple drug candidates or a broad pipeline. With SOTP, each drug or asset in the pipeline is valued separately using appropriate valuation methods. The individual asset values are then summed together to arrive at a total company value. This allows for properly capturing the potential value of early-stage or pre-revenue assets that may get overlooked in standard high-level company valuations.

SOTP also enables sensitivity analysis on individual drug assumptions. The granular approach provides a better view of how pipeline risks and opportunities contribute to overall company value. For example, a setback for a key late-stage candidate can be properly reflected in the SOTP value. This methodology is especially useful for biotechs with broad pipelines spanning early to commercial stage assets, as it disaggregates the varied pipeline into assets that can be valued individually.

Implications of Valuation Methods

The choice of valuation methodology can have major strategic and financial implications for pharmaceutical and biotech companies. In real-world pharmaceutical and biotech business scenarios, applying valuation methods other than risk-adjusted NPV often results in higher value estimations. Whether this variance is advantageous or not depends on the situation and transaction objectives.

Sellers Prefer Methods That Yield Higher Values

If you are a seller of assets such as biotech during an out-licensing deal, you may prefer alternate valuations like real options which yield higher asset value. However, an informed buyer such as a pharma will assess value using the risk-adjusted NPV method and would put structure and options to contain your price.

Buyers Look for Conservative Methods and Low Valuations

Conversely, when acquiring assets or in-licensing, pharma buyers prefer methods such as rNPV or DCF variants such as those used by venture capitalists, which yield more conservative valuations. This allows them to acquire or in-license assets relatively inexpensively.

Alternative Valuation Methods Have Tactical Uses

In a pharma corporate setting, such as in go or no-go decisions, new product planning, program value, etc., you may desire to showcase a higher value by utilizing alternative valuation methods such as real options, and there are legitimate reasons to do so. Why? Because a pharma company as a corporate entity will exercise the built-in options should there be needs in the future. However, as a base case, most pharma and biotech companies conduct rigorous risk-adjusted NPV-based valuations.

Valuation Methodology for Licensing and Partnering

Likewise, in business development and licensing scenarios, when you are a biotech party involved in out-licensing, you may find it beneficial to utilize alternative methods to risk-adjusted NPV. On the other hand, if you are pharma engaged in in-licensing, you would prefer a risk-adjusted NPV valuation method.

By understanding the goals of different parties, and the output and biases of various valuation methods, decision makers can select an appropriate valuation method for their pharma and biotech assets depending on business situations.

The Supremacy of Risk-Adjusted NPV Method

Presently, the risk-adjusted net present value (rNPV) methodology is widely utilized as the predominant valuation technique in the pharmaceutical and biotechnology sectors. There are several crucial factors that contribute to the supremacy of the risk-adjusted NPV method:

Alignment with Business Metrics and Owners’ Interests

Valuation employing risk-adjusted NPV and discounted cash flow analysis incorporates the most pertinent business metrics like cash flows, albeit probability-weighted cash flows, time value of money, cost of money, and so on. It is also aligned with the interests of asset owners, thereby helping to mitigate the ‘principal-agent’ problem commonly encountered in valuation exercises and decision-making processes.

Simplicity and Additive Property

The rNPV technique offers simplicity through the additive property of net present value (NPV). When a biotech firm undertakes a value-creating project (e.g., a new drug development program) with a positive NPV, the incremental NPV accruing from that drug project, adds to the overall value of the company. This feature makes it easier to assess and justify investments, assess the ex-ante contribution of the drug project to the company’s value, and evaluate its potential impact on the stock price.

Market-Aligned Methodology

Since capital markets value biopharma equities using the discounted cash flow models approach, adopting an rNPV method provides consistency and market alignment for practitioners and shareholders of biotech and pharma companies.

Best Practices for Accurate Pharma/Biotech Valuation

1. Estimating peak sales for biotech revenue forecasts

   Aim to estimate revenue generated from the biopharma asset using fundamentals, and do not use a historic revenue curve of a similar asset as a surrogate. When estimated correctly, the revenue curve in the biotech asset financial model is not likely to be a perfect S-shaped curve. The shape will depend on many factors such as competitive landscapes, loss of exclusivity of current modalities, pricing, launch sequence, etc. – they will impact the top line, which is critical in valuing a biotech company or asset.

2. Understand the revenue acceleration

   Again, this is not likely to be a nice hockey stick. An understanding of the drug profile, marketing, and sales force pushing and pulling capabilities of the pharma asset owner will affect the ramp-up time. If your asset is a platform or with a potential for multiple indications, the ramp-up time to peak sales might be longer and this is the key factor in valuing biotech platform companies.

3. Understand accruable top-line

   All of the estimated revenue might not go to the biotech company. Incorporate the provision for rebates and discounts so that you know the attrition in the top line. If there are licensing or partnering deals, assess their impact on the net revenue that could be booked by the company which in turn impacts the value of a biotech company materially.

4. Compute the free cash flow correctly

   Do not use gross profit or EBITDA or operating profit or contribution or net profit in the valuation as a proxy for cash flow. Compute the correct ‘free cash flow’ from profits by adjusting them for non-cash charges and working capital requirements. Free cash flow must be computed after paying all taxes. Do not exclude taxes by making the specious argument that the pharma company would adjust them at the corporate level or they vary across geographies.

5. Be aware of the cash flow in the computation

   The cash flow that you are calculating – is that available to the entire firm or is that available only to the shareholders of the company? The cash flow computation will dictate the discount rate (e.g. cost of equity or WACC) that you would use in the calculation of the value of the pharma business or asset. 

6. Pay attention to the loss of exclusivity

   Typically, modern complex pharma and biotech assets are not likely to experience a steep decline in revenue upon the loss of exclusivity as seen in traditional small molecule-based biopharma assets, so factor that in the valuation model. A good understanding of the underlying asset attributes is of immense help in valuing an asset in the pharma and biotech area. You might have to conduct a multi-stage biotech financial valuation modeling in order to capture cash flow accurately.

7. Compute the terminal value correctly 

   Is the biotech asset going to grow at the rate of the economy in perpetuity? Would ‘growth at the rate of the economy’ require further investment? Do not use the default perpetuity formula in your biotech financial modeling – there are several appropriate formulae. Use the one that meets your requirements – you might have to adjust them further. Address these points appropriately and adjust the terminal value to reflect the reality of your business. 

8. Include therapy area idiosyncrasies

   Factor in the impact of the therapy area in which the asset is competing or operating. Some therapy areas have a higher probability of success, while others have a lower probability of success. Incorporating therapy area idiosyncratic attributes will adjust the expected cash flow and probability of success (POS), and make the biopharma asset valuation work more specific.

9. Pay attention to the volume

   By volume, we mean the number of patients. If a drug has orphan or rare disease status, quite a bit of business case changes. Such assets might command better pricing power, get a tax benefit, benefit from regulatory assistance, and obtain extended exclusivity, which would impact biopharma valuation significantly.

10. Focus on key drivers 

    Several factors affect value materially, and these include the probability of success (converse of attrition rate), discount rate, and terminal value. Other drivers that affect value include revenue, working capital requirements and tax rate. At the very least, run a sensitivity analysis on key drivers. In addition to the key drivers, several other critical factors affect pharma valuation, so it is worth paying attention to them as well.

11. Keep alignment with the purpose of the valuation

    Valuation is used in a multitude of cases in pharma and biotech companies – internal business case assessment, capital raising, M&A, licensing and partnering, investing, marking asset to market value, damage assessment, litigation support, and so on. Valuation methods and associated assumptions depend on the purpose for which valuation is being conducted – the selection of valuation methods affects the computed value. 

12. Don’t blindly use others’ templates

    Refrain from using others’ spreadsheets as templates. Do not plug in your input to get a valuation – understand the assumptions and adjust the biotech financial modeling spreadsheet as required. A deep understanding of the pharma and biotech sector in addition to economics and finance helps to value life sciences assets properly.

Critical Drivers of Pharmaceutical and Biotech Valuation

A grasp of the key factors that determine asset value is vital for pharmaceutical and biotech valuation. For sellers, understanding the key valuation drivers helps capture fair asset value in licensing deals, acquisitions, and other transactions. For buyers, this understanding enables avoiding overpayment and making prudent investments grounded in sound financial analysis. Similarly, biopharma corporates can make informed and objective decisions in line with their shareholders’ interests.

Probability of Clinical Trial and Regulatory Approval Success

The probability of technical and regulatory success (PTRS) or probability of Success (POS), is the likelihood that a biopharmaceutical asset can successfully progress through pivotal clinical trials and ultimately gain marketing approval from regulatory bodies like the FDA or EMA.

Clinical trials’ probability of success affects the valuation of biotech assets and is one of the most critical drivers of value, and this probability is incorporated in the risk-adjusted NPV-based valuation. POS is not only the most critical valuation driver for biopharmaceutical assets but also for all other assets that go through phase-gated development processes, such as medical devices and diagnostics. Some factors worth considering are:

• The clinical trial and regulatory success probabilities can vary substantially across different therapeutic areas based on historical R&D benchmarks. For instance, oncology assets tend to demonstrate higher overall success rates in clinical testing compared to neurology assets.
• The probabilities of success differ significantly for orphan drugs targeting rare diseases versus mainstream drugs for larger indications. Rather than relying on blanket industry average probability of success rates, it is important to carefully incorporate clinical trial and regulatory approval probabilities that are precisely reflective of the specific therapeutic area and nature of the asset being valued.
• Novel formulations or new delivery mechanisms applied to existing molecule compounds with proven safety often tend to have higher technical success odds in development compared to entirely new molecular entities.

Most small pharmaceutical and biotechnology companies focus on some therapeutic areas, platforms, etc., therefore, the POS and the ensuing valuation should be reflective of their strategy.

Discount Rate Used in Discounted Cash Flow Analysis

Another key driver of pharmaceutical valuation is the discount rate. The discount rate, also known as the required rate of return or hurdle rate, represents the rate of return one expects to receive for taking on the risk of devising medicines which is the core activity of pharma and biotech companies. In conducting valuation:

• The discount rate utilized to calculate the net present value of projected future cash flows can have a significant impact on the valuation of pharmaceutical and biotech companies. The discount rate accounts for the time value of money and also adjusts for the inherent risk level associated with the drug development business, however, discount rate usage is a very eclectic practice in the pharma and biotech industry.
• Selecting an appropriate discount rate that is reflective of the asset’s estimated cost of capital is crucial for discounted cash flow analysis based rNPV valuations. Several options exist – one can use the discount rate as used by venture capitalists, compute the cost of equity, or calculate the WACC for the DCF models. Accurate calculation of discount rates is vital in order to arrive at a meaningful valuation of biopharma assets and companies.
• The discount rate is influenced by several factors including the risk-free rate of return, the risk premium tied specifically to the biopharma sector, and the time horizon or duration of the drug development undertaking.
• A higher discount rate will result in a lower net present value while using a lower discount rate will increase the net present value.

Terminal Value of Cash Flows

For many pharmaceutical and biotech assets, particularly those with longer exclusivity protections, the terminal value often represents a very considerable portion of the total calculated asset valuation derived from discounted cash flow analysis.

The terminal value is an estimate that captures the collective value of all the projected future cash flows expected beyond the discrete formal forecast period used in the primary discounted cash flow valuation model. Rather than making unrealistic assumptions and projections about perpetual cash flow generation extending infinitely far into the future, the terminal value incorporates those more distant future cash flows into the valuation.

Terminal value is typically determined using one of two common methods: the perpetuity growth method or the exit multiple method. The perpetuity growth method assumes that the cash flows generated by the investment will continue to grow at a steady rate into perpetuity. This growth rate is often based on long-term industry or economic projections. The exit multiple method, on the other hand, estimates the terminal value by applying a market multiple (such as the price-to-earnings ratio) to a future cash flow metric.

For a vast majority of biotech assets and companies, terminal value can be a significant portion of the total value, hence substantial thought should be given to the computation – that is why we say “watch your TV” – meaning terminal value – when undertaking pharmaceutical and biotech asset valuation.

Frequently Asked Questions

What is the most used valuation method in the biotech and pharma sector?

Risk-adjusted net present value (rNPV) analysis using discounted cash flow (DCF) techniques is the gold standard. rNPV incorporates clinical development risks into valuation modeling.

Why is risk adjustment vital for biotech valuation?

It accurately factors clinical trial failure rates and regulatory approval risks into cash flow projections, thus providing precise valuations. Risk adjustment captures biotech’s high clinical attrition.

How are clinical trial risks incorporated into pharma valuation?

Clinical development risks are modeled via cash flows adjusted for the probability of success using phase trial data specific to each asset and therapy area. This risk analysis accounts for technical uncertainty.

Why does the discount rate matter for DCF valuation?

The discount rate captures the biopharma cost of capital. Valuation is highly sensitive to discount rate assumptions, so using an appropriate investor opportunity cost is critical.

Why is the terminal value important in pharma valuation?

Terminal value captures the perpetuity of post-projection cash flows. For many biotech and pharma assets, the terminal value represents a significant portion of the net present value.

Why using the rNPV method in valuing biopharma assets is challenging?

rNPV is not just running templated DCF models. It requires expertise in both the biopharma sector and valuation methodology. Remember, GIGO (garbage in, garbage out) applies.

References

• B. Bogdan, R. Villiger, Valuation in Life Sciences: A Practical Guide (2010).
• Stewart, J., Allison, P. & Johnson, R. Putting a price on biotechnology. Nat Biotechnol 19, 813–817 (2001).
• Valuation: Measuring and Managing the Value of Companies by McKinsey & Company Inc. (2020).
• Numbers And Narrative: Value And Price In The Drug Business, Damodaran, A.
• Kellogg, David, and John M. Charnes. “Real-Options Valuation for a Biotechnology Company.” Financial Analysts Journal (2000).
• Cost of Capital: Applications and Examples by Shannon P. Pratt and Roger J. Grabowski (2008).
• Applied Corporate Finance by Aswath Damodaran (2015).

BiopharmaVantage is a specialist healthcare consulting firm that specializes in providing valuation services specifically for the pharma and biotech sectors. If you would like to explore how we can assist you, then please contact us.