Are Biotech Stocks Really Overvalued?

With 90% of clinical trials being rejected, finding the next big, profitable -- and successful -- drug is like looking for a needle in a haystack.

Biotech has always been hit or miss, though, with a complete inability to offer accurate estimates. Gilead Sciences (GILD 0.07%) has found a niche that has paid off long term, but that doesn't offer much hope when phase III trials are derailed more often than approved. Revolutionary treatment is the goal of all these companies, but it's impossible to know who will get there, let alone who will get there first.

A full transcript follows the video.

Michael Douglass: Is biotech over valued? This is Industry Focus.

Hi, Fools! Healthcare analyst Michael Douglass here with you today from the sunny hills of Italy. Actually, I'm not here today. This is a pre-recorded show. So, some minor details may have changed, but I think the overall conversation about biotech valuation will still be useful. It's a pretty timely topic because it seems that not a week goes by when someone isn't talking about whether biotech is overvalued, or undervalued, just on the whole.

Then I think as well, it's -- in a lot of ways -- a very timeless topic, because those conversations once a week have been going on for years. So, with those caveats in mind, Todd, let's go ahead and jump right into the question. Biotech valuation.

Todd Campbell: Biotechs are never -- it's never an industry that's easily valued.

Douglass: No!

Campbell: So hard to try and put a price tag on a therapy that could revolutionize treatment.

Douglass: I think that's such a crucial point to pull out. I'm going to emphasize it again. If you believe in efficient market hypothesis, look at biotech. This is the classical example of a market that is just deeply inefficient. It's hard to know whether a company with massive potential will actually live up to that potential.

When you have 90% of drugs failing -- that enter phase I failing -- ultimately to get to market, it's just almost impossible to appropriately valuate a company. Particularly when, you often even have -- and we talked about this in a recent Industry Focus health care episode -- when you'll have phase III drugs still failing. By some estimates, at a 30% rate.

It's very difficult to really know what a drug's going to be worth for a company and then just how revolutionary it'll be.

Campbell: Right. The other thing we have to remember as investors is, there are hundreds and hundreds of biotech stocks out there, but only a handful of them actually make any money yet.

Douglass: Right.

Campbell: So, the typical valuation metrics -- price to earnings ratio, price to sales ratio -- they don't really come into play when you're talking about biotech because most of them don't have sales and they don't have earnings. But that doesn't mean that there aren't some touchstones that you can -- things that you can look at and say "Is valuation crazy for biotech relative to other parts of health care, or is it crazy selectively?"

Douglass: Right.

Campbell: Maybe some parts of biotech are insanely priced while others maybe are a little bit more attractively priced.

Douglass: Right. And I think it's also important to note -- another distinction -- which is that small companies that are early in their growth cycle are just notoriously difficult to really understand what the opportunity looks like and to really value it. But there are bigger companies. There are the big pharmas, and you've got your big four, big biotechs and I think they're a little bit easier to understand because you have these large scale business models.

They're already making money. Offhand, I think they're all profitable. So, you can then use something -- at least more closely approximating traditional valuation metrics like price to earnings and price to sales. So, by those metrics how does big pharm and big biotech look to you, Todd?

Campbell: It's kind of interesting because you look at it and you say -- let's take, for example, Gilead Sciences. Full disclosure: I own it, I think you do as well, Michael.

Douglass: And The Motley Fool owns shares I think. Yeah.

Campbell: Yeah. Gilead Sciences: a behemoth. Leader in HIV treatment, leader in Hepatitis C treatment, $25 billion in revenue last year, OK? Now, there are some challenges ahead. There's going to be some competition that's going to come into the Hepatitis C market that could weigh down it's profitably, or profit growth. For that reason, in 2016 analysts think "Maybe your earnings are only going to go up about 1.5%, 2%; something like that."

Maybe it won't be blockbuster earnings growth in 2016. For that reason, they're only paying -- the forward price to earnings ratio for Gilead is just 10. It's at the lowest forward price earnings ratio for Gilead than it's had since 2010.

Douglass: Right.

Campbell: So, it's very inexpensively priced stock because people aren't too sure how it's going to shake out in this market, and what that impact will be on earnings in '16. So, it's hard for me to look at Gilead -- one of the biggest, most well-known biotechs out there -- and say "We have a bubble here." Especially when you look at something like Johnson & Johnson (JNJ -0.69%), which actually has a higher forward P/E than Gilead.

Douglass: Right.

Campbell: Still, it's looking to do low, single digit bottom line growth in 2016. So, I think when you're considering it that way you say "Maybe a big biotech like Gilead isn't too pricey, relative to something else out there." The other thing that struck me as I was preparing for today's conversation was that looking at a name like Celgene (CELG) -- which, again, another stock that I happen to own long. Full disclosure.

Celgene is expected to see its earnings growth 30% next year.

Douglass: It's still trading at 28x '15 estimates -- something like that.

Campbell: Yeah, 28x current, and then next year, less than 20x. You look on the big pharma side and you find a company that's expected to grow earnings by 30% and you come up with Bristol-Myers (BMY -0.27%). Bristol-Myers has a forward P/E ratio that's close to 30. So, is Celgene out of whack, or is Bristol-Meyers out of whack?

So, I think when you're looking at big cap biotech, it's hard to make the argument on a relative basis that these things are overvalued.

Douglass: Considering that they're growth stocks, and often many of them -- some of them are growth and dividend payers. Like Gilead being a good example.

Campbell: Exactly. I think where the big problem is and where people really need to make some distinctions here on overvalued, undervalued, right valued; is in the hot biotech stocks.

Douglass: Sure.

Campbell: Things like immunooncology drugs. The stuff where they're reengineering T cells to be able to better find cancer. Those valuations are a little bit crazy.

Douglass: Yeah. Well, and again, that's in part because you don't even know if the drug's going to make it out of the clinic yet. So, it's very difficult to appropriately value that company either way.

Campbell: Right. I heard that -- research has shown, and I think it's for oncology, 93% of drugs fail to make it all the way through clinical trials. Those are steep odds that are weighing against you. Yet you have companies out there like Juno (JUNO) that have a $4.6 billion market cap.

Douglass: Right.

Campbell: Now, maybe that will prove to be cheap down the road. But it's so early in the development of these drugs that it's hard to make -- it's hard to say that it's cheap. It's probably easier to say "Wow, that's pretty expensive."

Douglass: Right. Although, of course, from the other perspective if Juno -- or if another company -- ends up coming in and building a better mousetrap and fundamentally improving the standard of care for a major disease group -- like Gilead did with Hepatitis C, like a lot of folks are trying to do with diabetes, or cancer, and some of these other awful diseases -- who's to say that they're overvalued?

If that actually ends up happening.

Campbell: Yeah, that's the thing, right? Gilead was once a $5 billion market cap company, too.

Douglass: Yeah.

Campbell: Now it's $165 billion.

Douglass: Right, and I know you and I both wish we'd gotten in earlier. You can't win them all, I guess.

Campbell: No. I really think, when push comes to shove, and if you were to say "Michael, Todd; what'd you think? Are these things too pricey?" I would say that -- the time of just being able to go out and buy any biotech is probably past us.

Douglass: Sure.

Campbell: Instead, you need to do your due diligence. You need to be selective, and you need to do your research.

Douglass: Yeah. At the end of the day, this is something that actually -- you end up having conversations about it in banks a lot, too. You might have a bank trading at 2x book, or something like that. Then at the end of the day you're paying for quality. If you're confident in the business and its business model and its growth prospects -- maybe a little bit less so for banks, of course.

Healthcare's a much more growthy space than financials. Then you need to think about what you think is the opportunity with that company. I have certainly hopped into companies that looked pretty darn richly valued, but which I believe will pay off long term for me. I know you have too, Todd. So, it's one of those things where, I think you paint a broad brush stroke with the sector, and it overdoes it. You're overstating your case.

What you have to do is look at individual stocks because they're going to be undervalued and overvalued stocks by your perspective, and you want to then think about what the opportunity looks like and whether there's a reason for that valuation to be so cheap, and if you like what you see then there may be a really nice long term opportunity for you.

Campbell: I 100% agree with that. 100%. It's a market of stocks and there's always going to be winners, there's always going to be losers, and you have to remember that valuation is kind of an issue of timing. Something may seem overvalued right now at 20x earnings, but if in five years from now those earnings have doubled, was it really overvalued to buy it today?

Douglass: Yeah. That is, I think, probably the key question folks are going to want to ask in health care and biotech. Folks, thank you for giving us a listen today. I will be back in the office next week for health care Industry Focus. Todd, as always, a pleasure to talk to you. Shoot us an email if you have a question, or if you want to debate a point.

Our email is [email protected]. Again, that's [email protected]. For The Motley Fool, I'm Michael Douglass. Thanks much, and Fool on!