Biotech stocks are well-known for their eye-popping valuations. What casual investors may miss, though, is that classic valuation metrics -- such as the price-to-earnings ratio -- rarely capture the true value of a biotech company. Successful biotech investing, after all, really boils down to understanding a company's deep value -- not necessarily its free cash flows, near-term earnings projections, or even its financial capacity for business development.
What is deep value in the complex world of biotech? Deep value is anything that creates a bona fide competitive moat. It can be a company's uncanny ability to repeatedly bring important new therapies to market, historical dominance over a particularly high-value disease indication, and/or a key figure in the management team.
In short, biotech companies earn premium valuations by consistently proving that they can stay one step ahead of the competition -- a herculean feat that most companies in the space flat out fail to do. The lesson here is that investors would be wise to take traditional valuation metrics with a huge grain of salt when it comes to biotech, and instead, focus squarely on a company's competitive positioning.
Two seemingly expensive biotechs that are actually cheap
The Chinese biotech BeiGene, Ltd. (BGNE -2.62%) and the rare disease drug giant Vertex Pharmaceuticals Incorporated (VRTX -1.06%) are prime examples of this counter-intuitive, yet absolutely fundamental, aspect of biotech investing. BeiGene, for its part, is presently trading at a jaw-dropping price-to-sales ratio of 30.5. To put this metric into the proper context, the average price-to-sales ratio for the entire healthcare sector currently stands at 5.81. Investors are thus paying an extremely steep price for BeiGene's shares, at least based on this oft-used metric.
Vertex's stock, on the other hand, sports a price-to-earnings ratio of 28.4 right now. That figure is almost double the average for the whole of the biotech industry. So, again, Vertex comes across as wildly overvalued at first glance. But that's an entirely erroneous conclusion.
Why are BeiGene and Vertex worthy of these sky-high valuations? BeiGene has quietly become the gatekeeper for top biotechs looking to gain access to the massive Chinese healthcare market. Last year, for instance, Amgen inked a deal with BeiGene to market several cancer meds in China, and before that, BeiGene had a marketing deal in place with Celgene.
If these marquee marketing deals weren't enough, BeiGene also offers investors a highly diverse pipeline of proprietary cancer medicines. BeiGene should thus turn out to be one of the fastest-growing biotechs in the world during the current decade, thanks to its rather unique access to the enormous Chinese healthcare market and robust oncology product pipeline.
Vertex's spicy valuation stems from its utter dominance of the cystic fibrosis market. Cystic fibrosis is a genetically based lung disorder that gets progressively worse over time. Vertex, however, has drastically improved the lives of many patients with this disorder through the development of game-changing medicines such as Trikafta. Trikafta, in turn, is widely expected to grow into one of the best-selling medicines in the industry early in the new decade.
Wall Street, for instance, has the drug's peak sales pegged at a whopping $6.6 billion. Most importantly, though, Vertex appears poised to maintain its virtual monopoly over cystic fibrosis for the foreseeable future. That's the type of rock-solid competitive moat that warrants a top-shelf valuation.
BeiGene and Vertex may have pricey valuations in the classic sense, but that doesn't mean these two top biotech stocks won't continue their winning ways. The bottom line is that these two companies have carved out a highly profitable and defensible niche within the high-growth biopharma space. There are almost no other companies in this industry that can even remotely make that claim. And that's the fundamental reason investors shouldn't be put off by BeiGene's and Vertex's stately valuations.