Valuing biotech companies that lack an FDA- or EMA-approved product is a tricky endeavor, to put it mildly. So, to help shed some light on this complicated issue, we asked three of our healthcare contributors how they go about calculating a workable valuation metric for clinical-stage biotechnology companies. Here's what they had to say.
Estimating your chickens before they hatch
Kristine Harjes: In order to value a clinical-stage biotech, you must first attempt to value the company's pipeline. For simplicity's sake, let's consider a company that has one lead candidate in development. We can determine a reasonable expectation for this drug's sales by using the following formula:
Size of patient population * expected market share * price of drug = sales
Let's take these elements one by one. Size of the patient population is usually very easy to find with a quick internet search. If the drug targets a chronic disease, you'll want to find out how many total people have the disease. If it's a one-time cure, you'll want to note how many new cases of the disease are diagnosed each year. Additionally, if the drug targets anything later than first-line treatment, you'll need to investigate how many patients progress past the first line of therapy.
Expected market share has two components. Does the drug have competition? If so, how does it stack up against its competition? If it beat the standard of care in trials, it's safe to say it'll steal away a good bit of market share. However, if it hasn't been tested head-to-head, it might only garner a small share, as many doctors prefer to stick to prescribing a familiar drug.
Speaking of competing drugs on the market, this is just about the only way to estimate the price tag. If there isn't any other similar drug out there, your job just got a bit harder. This is likely the case with rare disease drugs, which almost always price in the low 6-figures.
Sound like a lot of moving pieces and guess-work? You're correct. Fortunately, there are many analysts out there who will do this heavy lifting for you -- and it's your job at that point to check that their estimates seem reasonable. In fact, knowing what goes into a calculation can help inform your trust in these estimates.
We can now turn to the bottom-line question: How does a peak sales estimate play directly into the valuation for a company? Historically, biotechs are valued at about three times the peak annual sales of the company's lead candidate. If chances of approval look good, which you can judge by how far along the drug is and the strength of the trial data, and yet shares are still trading for far below three times peak sales, you may just have found yourself an undervalued gem. And if the company has other drugs in development, that's a helpful hedge against the worst-case scenario: the FDA rejecting the drug, turning its peak sales to $0.
Cory Renauer: Far too often beginning -- and seasoned -- biotech investors imagine the pot of gold at the end of the rainbow without factoring in the odds of getting there. When it comes to clinical-stage drug candidates, though, adjusting for risk of failure can help you avoid biotech stocks with delusional valuations, and spot overlooked bargains.
Let's look at an example from Celldex Therapeutics (NASDAQ:CLDX). Its lead candidate, glembatumumab vedotin (glemba), is in a phase 2 study that could support an application for treatment of breast cancer patients with tumors that lack three important targets employed by existing treatments. Each year an estimated 170,000 women are diagnosed with "triple-negative" breast cancer, but it seems a large percentage have tumors that express glemba's target.
To illustrate adjusting clinical stage biotech assets for risk, we'll assume the drug's total annual patient population is around 50,000 patients at a list price of $100,000 each. Assuming the drug can capture the entire market, this gives us a peak annual sales estimate of $5 billion, which suggests Celldex Therapeutics' recent market cap of just $448 million is grossly undervalued.
Before you get too excited, it's important to factor in risks associated with drug development. Between 2006 and 2015, just 8.1% of oncology candidates that entered phase 2 trials went on to earn FDA approval. Adjusting for this dismal rate of success lowers the amount of peak annual glemba revenue we can statistically hope for to just $405 million.
Although investment in Celldex would involve significant risk, adjusting for the odds of failure still leaves us with a clear view of a stock in value territory. Toss in a solid balance sheet, and additional oncology candidates a bit closer to the finish line, and this biotech stock looks like a bargain you can feel confident about.
George Budwell: Clinical-stage biotechs are extremely difficult to value because of the sheer complexity in breaking down even a single drug's real world commercial opportunity -- not to mention the daunting task of working through an entire pipeline of experimental product candidates.
So before building more robust multivariate models to assess the probabilities underlying different events during a drug's march toward the market and its subsequent uptake, I start off by asking three fundamental questions outlined below to see if a stock even warrants a deeper dive.
1. Is the company's lead drug candidate novel in terms of its mechanism of action or indication? Or is it better characterized as a "me-too" drug indicated for an already crowded market?
This question speaks to the likelihood that a regulatory agency may be willing to overlook some minor -- or even major -- problems with a drug's clinical dataset or regulatory application during the review process.
Sarepta Therapeutics' controversial Duchenne muscular dystrophy (DMD) drug Exondys 51, for example, apparently got a pass from the FDA due to the high unmet medical need for its proposed indication -- despite the drug's exceedingly small mid-stage trial and questionable efficacy results.
A drug indicated for a market supporting multiple products such as advanced melanoma, on the other hand, may require a near flawless regulatory application in order to convince regulators to approve yet another expensive medication.
2. How experienced is the company's management team at bringing an experimental drug all the way to market?
It's no secret that experience plays a huge role in convincing regulators to first approve a drug, and then get payers to provide coverage to maximize a drug's commercial potential. If a company lacks experience on both fronts, it can spell disaster for shareholders.
3. Will payers readily offer coverage upon approval, or will top opinion leaders hesitate to add it to their formularies?
Unfortunately, a positive late-stage trial and the FDA's blessing are only the first of many major hurdles on a drug's path toward becoming a profitable commercial-stage product. Equally important is that payers are willing to cover a drug, and that's often not the case for a variety of reasons.
In all, I begin the lengthy valuation process by first deciding if the company's lead drug candidate has a reasonable shot at garnering an approval, finding a profitable niche, and getting broad insurance coverage. A shocking two-thirds of all experimental drugs, after all, fail to ever reach the commercial stage of their life cycle -- meaning that the vast majority of clinical candidates actually sport a big goose egg in terms of their real world value proposition.