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Exelixis, Inc.
Valuing Development Stage Biotechs

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By doglov
April 4, 2008

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I recently posted elsewhere how I estimate a value for Exelixis (but it could be applied to other development stage pharma-co's) when they have no products and very little revenue. I thought I would cross-post this here in an effort to increase traffic on this board and share some of the things I have figured out. I'm not claiming that this is the "correct" way to do this, but it all makes sense to me, based on what I know and have read and learned so far.

With this method you can estimate what fair-value impacts should be to various "shocks" from developmental "surprises" (news that occurs with-out warning). You can also play what-if scenarios. There are a few ways to go about this, but no matter how you do it, you must make many assumptions.

For each compound:
First I estimate the time to market assuming the drug is approved. I also, estimate the probability of approval of the drug (there have been some studies about the historical success of oncology clinical trials). These values depend on how far along the drug is in clinical trials. I also estimate, based on what Exelixis says, what their share of royalties are for the drug (they don't always explicitly say). I also estimate what the yearly revenues from the drug would be if it is approved.

From all that, I come up with "expected" revenues that should occur in the estimated ammount of time. For example if a compound has a 20% chance of producing $350M in 4 years, and it is shared 50-50 with a partner, then the expected revenue from the drug in 4 years is
0.20*0.50*$350M or $35M.

The next step is to discount all future earnings. We can't count future earnings fully right now because if we could get less money right now we could invest it in something of similar risk and end up with (on average) with the $35M in 4 years. Some think the discount rate should be related to a company's "beta" (this is according to CAPM theory). The theory gives us a ball park number for EXEL of around 20% or so. At 20% discount, today's value of $35M is around $17M.

If you add up all of the "present values" of the "expected" earnings of all the compounds you end up with a sense of how much future sales (for one year) are worth today.

You could multiply that by a common P/S (price-to-sales) ratio for the industry as one way to get a ball-park estimate of a fair current market cap, but you have to construct P/S ratios yourself subtracting out net assets (like cash less debt) from the capitalizations of the companies you are looking at. And then you have to add the net assets for EXEL back in. [ok, I realize I said that very concisely and it might be hard to follow - if you were still with me up to here]

Another way is to essentially work out the present value for all future yearly revenues of a compound. In this case you have to guess how long you will make money off a compound. Then you have to guess a factor for sales margins.

The last thing to do which I haven't really tackled myself very well is to figure out what your cash burn is going to be, remembering that future cash burn is also discounted and doesn't cost as much today.

So you see, there are mostly assumptions here but that is all anyone has at this point anyway. There is some evidence that perhaps Exelixis is better than other companies in discovery & preclinical work and that there may be better odds of success than most give them credit for, but the jury is still out on that and I don't think anyone is pricing that in at this point.

One other thing to note is that the discount rate is not constant over time. If Exelixis has some success over the next few years and reduces their dependence on outside capital (so far they have had to raise capital through either shareholder or pipeline dilution), then their discount rate should get smaller and move towards the "risk-free" rate (the rate of return you can get in a zero-risk investment). When this happens, future earnings become worth more in the present.