Investing in small biotechs is more speculative in nature than investing in profitable companies. However, there are methods that can be used to make it less like gambling and more like actual investing.
What exactly is biotech gambling, you say? It is investing in a drug program without a realistic consideration for the value the drug brings to the company or the risk of development, and then closing your eyes and hoping for the best. That is definitely not a strategy that I advocate. Instead, a more successful approach can come from thinking about biotechs in terms of the value of the products being developed, the likelihood of approval, and the current worth of those products.
This is the first in a series of articles outlining a systematic approach toward analyzing biotech companies as potential investments based upon the present value of their drug programs. The first step in this quantitative methodology is to identify the markets targeted by the company, and a range of possible sales that could be achieved if it's successful in developing the drug.
Identifying the population
The first step in forecasting future sales is to narrow down the population that the drug will serve as much as possible. For example, it is not sufficient to say that a drug will be used in the treatment of psoriasis. Psoriasis has a range of severity, and patients with mild forms of the disease are treated with different types of drugs than patients with severe forms. Many diseases are stratified in this manner, where different drugs are used to treat patients in the different niches. It is important to identify, with as much precision as possible, the exact patient population, because a failure to put the drug in the correct niche will lead to an inappropriate sales estimate.
For late-stage clinical drugs, the specific patient population can be found by either looking at the company's website or by using a site such as ClinicalTrials.gov.
When the exact patient population is identified, the number of patients in that group can often be discerned through researching medical literature at Medscape, using resources from medical societies like the American Society of Clinical Oncology, or browsing disease advocacy websites such as the National Multiple Sclerosis Society. And when all else fails, there is always Google.
Some questions for narrowing down the patient population include:
- Is the drug for a mild, moderate, or severe form of the disease?
- Will the drug be used for first-, second-, or third-line treatment if applicable?
- Are there biological markers, such as protein expression, which limit the use of the drug to certain patients?
- After taking these factors into consideration, how many patients are eligible to use the drug?
Guessing market share
The market-share estimate is probably the single biggest source of error in this process. There is simply no way to know if a drug will have 5% or 30% market share in the future. Therefore, it is my feeling that it is best to be conservative in the estimate.
If a drug looks to be effective and is targeting an underserved market with minimal competition, then I tend to think it is acceptable to use a fairly high estimate, such as 50% market share. I don't like to go much higher than that, though, as even in the best of circumstances there will be patients that cannot use the drug for one reason or another. There can be conflicts with other medications, payment issues, or exclusions based on medical conditions the patient may have.
If a drug is entering a competitive market, it is useful to identify the current market share held by the competing products. Factors influencing market share, in this instance, are the frequency with which patients switch from one drug to another, the strength of the marketing organizations (is it a small biotech competing against Pfizer (NYSE: PFE ) ?), and the relative quality of the clinical data that goes into the product label. A rule of thumb I use is to divide 100% by the number of drugs on the market, including the drug of interest. If a drug is going to be No. 4 in a market, I generally assume that it will attain something less than 25% market share (100% divided by 4).
The annual cost of therapy is the last piece of the puzzle. Biotech companies will almost never tell you what they will charge for a drug prior to approval, so this, too, must be an estimate.
If there are comparable drugs already on the market, it is certainly reasonable to make the assumption that the drug will be priced in line with the competitors, give or take a bit. If the drug has superior efficacy or fewer side effects against the competition, a pricing premium is likely, and should figure into the estimate. On the other hand, if the drug is entering a market with an entrenched competitor, a lower price may come into play to encourage uptake and accelerate sales volume.
It is important to note that you cannot use the retail price charged to patients. That would assume that every dollar spent by the consumer ends up in the pocket of the company. This is not the case. There are middlemen, such as wholesalers and pharmacies, that each take their cut. According to Michael Miller in the superb Entrepreneur's Guide to a Biotech Startup, the drug company receives approximately 70% to 75% of the drug's retail price.
Instead of retail price, it is preferable to use the average wholesale price (AWP), which can be found in the Red Book.
Percentage of current market size
The process outlined above can be used when the overall market size is not known. A different approach to estimating potential sales is to find out the sales of the current drugs used to treat the disease to determine the overall market size. Sales projections for a new entrant into the market can then be based upon attaining different market shares. For example, in a market worth $1 billion, capturing 10% market share would lead to sales of $100 million.
This is the easiest approach for diseases where the patient population is well served with existing drugs, such as the market for statins to lower cholesterol. For modeling sales over a number of years, it is important to factor in if the market is growing or shrinking. It is also important to note if one of the standards of care is going to soon be available as a generic, as this can shrink the size of the overall market with patients selecting the lowest-cost drug.
This method is only applicable if an established market for the product already exists and doesn't really apply if the new drug will be targeting an underserved market.
The general formula for estimating potential future revenues from a drug's sales is:
revenue = total number of patients x market share captured x wholesale drug price
Forecasting potential revenues from a drug is clearly based on subjective math and, as a result, is more art than science despite the desire for a precise estimate. The variables that go into the forecast are complex and difficult to predict with accuracy. Due to the uncertainty, it is important to err on the side of conservatism. Despite the difficulties, it is a process that must be performed as part of determining what a biotech company is worth.
It is always best to clarify somewhat abstract concepts with a concrete example. So in my next article, I will run through an example to demonstrate how this process applies to a real-life situation.
Fool contributor Charly Travers was the guest analyst forMotley Fool Hidden Gemsin April, when he highlighted a promising, new biotech. To read more by Charly on the exciting prospects of the industry, check out his recent articles: