Don't let it get away!
Keep track of the stocks that matter to you.
Help yourself with the Fool's FREE and easy new watchlist service today.
Valuing biotechs is difficult. There's no simple formula because you have to factor in an unknown, ever-changing risk factor that's different for each biotech.
Of course, if there were two drugmakers with essentially the same risk, it would be a lot easier to evaluate. Three would be even better.
That's what we have with the three obesity drugmakers. It isn't a perfect comparison, but it's easier to figure out what one drugmaker might be worth based on the value of the other companies.
A crowd of three
VIVUS (NASDAQ: VVUS ) was first to market with Qsymia. The drugmaker currently has a valuation of about $950 million. The biotech also has an erectile dysfunction drug, Stendra, but it hasn't found a partner to market the drug in the U.S., so let's call any upside there a bonus.
Arena Pharmaceuticals' (NASDAQ: ARNA ) partner Eisai recently launched its obesity drug Belviq. The drug is arguably less efficacious than Qsymia, but the side effects are also much milder. Beyond Belviq, Arena has a four drugs in the pipeline, but they're all in phase 1 or earlier. So, like Stendra, we'll call them potential upside but not ascribe much value. Arena has a slightly higher market cap of about $1.1 billion.
That brings us to Orexigen (NASDAQ: OREX ) , which doesn't have a drug on the market because the Food and Drug Administration made the biotech run an additional clinical trial to check for potential cardiovascular side effects. Data from that trial are expected by the end of the year. From the values of VIVUS and Arena, it's pretty clear Orexigen should be valued around $1 billion if its obesity drug Contrave is approved.
Determining Orexigen's downside is more difficult. If you want to be conservative, figure Orexigen will drop to its cash value, or about $96 million as of June 30, if the safety study fails.
In reality, Orexigen isn't really dead if the interim results fail to clear the drug by a statistically significant margin. The biotech will get a second shot when the trial concludes in 2017. The downside is probably closer to $150 million, which was the value that investors gave the company after the FDA rejected Contrave in 2011.
Putting it all together
Figuring out if Orexigen is a good buy is simply a function of the likelihood of a positive result and the two expected valuations. Given the current market cap of $625 million, we can solve for the anticipated likelihood of approval with this formula:
Value on approval * Likelihood of approval + value after negative trial * likelihood of a negative trial = current value
Plug in the numbers and we get.
1000*X + 150*(1-X) = 625
Or the likelihood of approval = 56%.
If you think there's a greater than a 56% chance of a positive clinical trial and subsequent approval, then Orexigen is a good buy.
Figuring out the likelihood of a positive clinical trial is tough because investors don't have much to go on. It's not like Orexigen ran a phase 2 safety study in this population.
On one hand, the bar is pretty low. Contrave doesn't have to beat the placebo; it just needs to not create more cardiovascular events -- heart attacks, strokes, and the like -- than placebo. But there's not much to go on with interim results, just 87 events among the 10,000 enrolled patients. It's easy to see how the drug group taking Contrave could look worse by chance alone.
I think it's more likely than not that the trial is positive, but I'm not convinced there's enough of a margin of safety to justify buying at this valuation.
Finding game-changing biotechs
The best way to play the biotech space is to find companies that shun the status quo and instead discover revolutionary, groundbreaking technologies. In The Motley Fool's brand-new FREE report "2 Game-Changing Biotechs Revolutionizing the Way We Treat Cancer," find out about a new technology that big pharma is endorsing through partnerships, and the two companies that are set to profit from this emerging drug class. Click here to get your copy today.