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Market whims and whispers can (and often do!) send shares in biotech stocks surging or plummeting, but managing volatility isn't the only challenge facing biotech investors.

Biotech investors also need to manage seemingly canyonesque difference between a biotech company's real, or financial, value, and its perceived value, or the value associated with potential revolutionary medicines.

Although vexing, this valuation conundrum is isn't impossible to resolve. Read on for insight into how biotech investors can bridge this tricky valuation gap.

Standards don't apply
In most businesses, determining the value of the company can be pretty straightforward. Investors have a bevy of financial data and ratios that can be evaluated, digested, and considered to estimate fair value.

For example, book value shows investors how much a company would be worth if all its assets were sold and all its bills paid. The book value of a company puts a quick and dirty brass-tacks value on a company that an investor can use as a baseline.

However, book value has little application in the world of biotech investing, because it can be years before a biotech researcher's hypothesis can be proved to the extent necessary to win over global healthcare regulators, such as those at the FDA.

Since the time associated with commercializing an unproven therapy means most biotech companies are continuously raising and spending money, and since there's often little in the way of assets beyond beakers and lab coats to liquidate, book value tells us very little about how much a biotech stock may or may not be worth.

Similarly, other traditional measures of value, such as the price-to-earnings and price-to-sales ratios, or P/E and P/S, similarly come up short because most biotech companies haven't yet commercialized any products, so they don't have any profit or sales to measure!

Making educated guesses
Since financial ratios such as book value, P/E, and P/S are lacking when it comes to figuring out how much a biotech stock is worth, investors need to turn to other less black-and-white measures to determine value.

Almost all of these other valuation methods are forward-looking in nature, which means that they're subject to significant room for error; however, absent other options, they remain an investor's best choice.

Discounted cash flow, or DCF, is one of the most frequently used approaches.

In calculating DCF, investors need to estimate the number of patients a potential drug could treat annually, come up with a price that a company could fairly charge for that therapy, and then discount that amount by a company's expenses, the likelihood of regulatory approval, the cost of capital, and the time value of money.

Let's consider an example.

Let's assume that biotech company XYZ Pharma is working on a therapy to treat pancreatic cancer, a tough-to-treat illness with a patient population of roughly 45,000 Americans.

Since there are few effective therapies for pancreatic cancer, let's assume that if XYZ's approach succeeds, it will capture 25% of the market in year one, 35% of the market in year two, and 50% of the market from year three to year ten.

Further, let's assume that since other recently approved cancer therapies cost roughly $10,000 per month, or $120,000 annually, XYZ would similarly price its drug at that level.

Using a simple formula that multiplies the number of addressable patients that could be treated by the drug by the estimated annualized price for the drug, you would determine that gross annual revenue for this drug would be $1.35 billion in year one, $1.89 billion in year two, and $2.7 billion for years three through ten.

However, that value doesn't reflect the annual costs associated with running the company, so you need to come up with a fair guess at XYZ's expenses and then discount your sales projection by that amount to get an estimate for free cash flow.

One way to do that is to consider the percentage of revenue that is free cash flow for biotech peers that have already launched products, such as Celgene and Amgen. Those two companies have a free cash flow to revenue rate of roughly 25% and 30%, respectively.

For simplicity's sake, let's walk through the rest of the DCF calculation using year one of XYZ's sales as an example.

If we use a 30% free cash flow rate as a proxy and therefore discount the $1.35 billion of year one's sales by 70%, it gives us an annual free cash flow figure of $405 million that year.

That's a good start, but since XYZ's drug is still in phase 3 trials, and 40% of phase 3 studies fail, I also want to discount the likelihood that this drug fails by reducing the $405 million by an additional 40%. That gives us a new value for this drug of $243 million. 

Further, I also want to discount that $243 million by the weighted average of XYZ's cost of capital, which takes into consideration financing costs associated with issuing equity or taking on debt. In biotech, the typical weighted average cost of capital is 8.17%, so adjusting for that amount gets us to a value of about $225 million for this drug in its first year on the market.

Now that I've done this calculation for year one, I can do it for the remaining nine years for my model, with one caveat. I need to increase the discount rate for each year in my model to reflect the diminishing value of money over time. I can do this by dividing my adjusted free cash flow figure by 8.17% to the power of the year being considered. For example, the formula for the third year in my model would be: adjusted FCF/1.08173. As you can see in the following table, doing this reduces the value of XYZ's peak sales over time.

Source: Author's calculations

Totaling up each of the ten years of fully discounted cash flows gives me a value of $2.89 billion, to which I can add any cash or debt. I can then compare this value to XYZ Pharma's market cap. If XYZ's market cap is bigger than this amount, then I might decide it's overpriced; however, if the market cap is lower than this amount, then I might decide that it's undervalued.

A good starting point
This is an imperfect calculation, and it relies on a lot of assumptions, which makes doing these calculations very dangerous. Small changes in the patient population, pricing, corporate costs, or the discount rate can result in big change in valuation. Additionally, investors should remember that even if a drug does well in late-stage trials, the FDA can still reject it over concerns tied to safety or how the trial was conducted.

For those reasons, the DCF valuation calculation can't be the only thing you consider when making a biotech buy-or-sell decision. However, it can serve as a valuable data point for your analysis.