Valuing developmental-stage drug companies is difficult, to say the least. It sometimes seems that the wild swings in stock price have more to do with investors' irrational expectations and overreactions than anything else.

A shining example
Take VIVUS (NASDAQ:VVUS), which spiked more than 25% on Friday.

VIVUS can't technically be called a developmental-stage drugmaker -- it sells Muse, an erectile dysfunction product that competes with more well known products like Eli Lilly's (NYSE:LLY) Cialis and Pfizer's (NYSE:PFE) Viagra -- but given its market cap of less than $500 million, it certainly trades like one.

Digging a little deeper we see that the company's abstract for next month's meeting of the American Diabetes Association came out Thursday, containing data from a trial testing its obesity drug candidate, Qnexa, as a treatment for diabetes.

While data from the trial is promising -- the drug lowered the HgbA1c (a measure of longer-term blood glucose levels) by 1.1% versus just 0.6% for the placebo -- there's some important data missing from the abstract. First, information for only the first 16 weeks of the 28-week trial was available. Second, for diabetes treatments, the HgbA1c test isn't like the limbo -- this isn't a "how low can you go" sort of thing. Instead, medical groups recommend that HgbA1c levels be below 6.5%-7.0%, so it's important to know what percentage of patients Qnexa helped reach this goal.

The additional data should be in the full presentation, but until then I'm not going to get ecstatic about Qnexa as a treatment for diabetes.

Say it twice, maybe investors didn't hear the first time
But perhaps investors were excited about the weight loss seen in the diabetics, instead.

After just 16 weeks, subjects taking Qnexa lost an average of 6.2% of their body weight, compared to just 1.2% for subjects taking the placebo. Not bad considering that diabetics have a notoriously harder time shedding pounds. Anything around 5% or greater in weight loss with few side effects could compete against current obesity treatment options from GlaxoSmithKline (NYSE:GSK) or Abbott Labs (NYSE:ABT).

Still that weight loss shouldn't have been a big surprise. The company released phase 2 trial data in May 2006 that showed Qnexa helped obese patients shed 20 pounds more than those taking a placebo. Based on those results, VIVUS has already completed enrolment for its phase 3 trials for Qnexa as a weight loss treatment. While the phase 2 data thus far has been fairly impressive, it will be the results of these larger, longer trials that tell us if the drug really works. Investors won't have to wait too long to find out, as the first results should be available before the end of the year.

Competing with generics
Drugmakers usually have some time before competition from generic drugs can start, but VIVUS may see generic competition for Qnexa as soon as it makes it to market. You see, the drug is a combination of phentermine, an appetite suppressant best known for forming part of the infamous fen-phen weight loss drug formerly marketed by Wyeth (NYSE:WYE), and the active ingredient in Johnson & Johnson's (NYSE:JNJ) Topamax, which isn't used for any weight loss-related conditions.

Phentermine is available as a generic right now, and Topamax will be available as a generic later this year. By the time Qnexa gains FDA approval, it will be possible to take two generic pills and avoid paying the presumably higher cost of Qnexa. VIVUS has done some things to differentiate Qnexa from the generic drugs -- for instance, it contains 92 milligrams of the active ingredient in Topamax compared to the 100-milligram pills available now and for its imminent generic -- but whether that will be enough to persuade doctors to prescribe it and insurers to pay for it is yet to be determined.

While I can't see how the release of the ADA abstract means that VIVUS is worth 25% more, I don't think it's really overvalued at this point. Arena Pharmaceuticals also has a weight loss drug in phase 3 trials and has a market cap just slightly less than VIVUS. Considering that VIVUS has one drug on the market already, it looks like investors are properly factoring in Qnexa's generic drug issues.

Valuing small drugmakers may be hard, but it looks like investors got it right with VIVUS -- albeit a little late.