Investing in biotechs can be very profitable. Finding them before they've secured phase 3 results is the key to getting those results; Dendreon (Nasdaq: DNDN) is up 9.4% since receiving FDA approval for Provenge, but it's up 494% since it released phase 3 data last year.

But sometimes investors get a little too excited about upcoming phase 3 results, which can drive up a company's value and cause the risk-reward proposition to get out of whack.


Market Cap (in billions)

Enterprise Value (in billions)

Vertex Pharmaceuticals (Nasdaq: VRTX)



Regeneron Pharmaceuticals (Nasdaq: REGN)



Incyte (Nasdaq: INCY)



Source: Capital IQ, a division of Standard & Poor's.

Low risk, low reward
How did Vertex manage to get such a large value without phase 3 data for its lead pipeline drug, telaprevir? It picked a pretty good disease to treat.

Hepatitis C is one of the rare diseases where drugs respond consistently over the different phases of the clinical trial marathon. You'll often see drugmakers jump on positive phase 1 trials in hepatitis C -- Achillion Pharmaceuticals went up more than 14% last week, for instance -- because phase 1 data is a better sign that the drug really works than phase 1 results in other diseases.

The sheer volume of potential customers is also built into Vertex's market cap. The current hepatitis C treatments -- Roche's Pegasys and Merck's (NYSE: MRK) Pegintron -- only cure about half of the patients. Their high fail rates, not to mention awful side effects, have left a lot of patients waiting for next-generation treatments.

Vertex is the highest priced of the three in the table, but it's also probably the least risky -- at least in terms of falling from the sky because of a failed drug. But on the same hand, don't expect positive phase 3 results and an approval from the Food and Drug Administration to drive the stock all that much; everyone already expects that.

A one-hit wonder without the hit (yet)
Regeneron Pharmaceuticals has a drug on the market, but Arcalyst only brought in about $5 million in sales in the latest quarter because it treats an ultra-orphan disease (a condition that affects very few people). Most of Regneron's $2.1 billion enterprise value is caught up in its pipeline.

The company has three treatments in phase 3 trials. Arcalyst is being tested for gout, and Regeneron has an antibody against VEGF -- which promotes blood vessel growth -- that is being tested in both cancer and eye diseases such as macular degeneration.

Regeneron also has drugs falling in behind its lead candidates. The company recently struck a deal with sanofi-aventis to develop four to five new drugs per year through 2017.

Having multiple shots on goal is a good thing, but you're going to have to pay for the privilege.

You don't know JAK, but Incyte does
Incyte's lead program targets JAK proteins, which are involved in inflammatory diseases and cancer. The drug, INCB18424, is in two phase 3 trials for myelofibrosis, a bone marrow disease. Novartis (NYSE: NVS) licensed the drug outside the U.S. last year, which should give investors a little bit of confidence that someone else thinks it's worth taking a risk on.

Incyte also has an oral rheumatoid arthritis JAK inhibitor drug, INCB28050, which it licensed to Eli Lilly (NYSE: LLY) that's helping drive its value. The rheumatoid arthritis market is huge and just asking to be taken over by an oral drug instead of the current injected and infused drugs. But INCB28050 hasn't proved itself in a phase 2 trial, so I'm taking a wait-and-see approach.

Be careful out there
The bigger they are, the harder they fall couldn't be truer for developmental-stage drugmakers. Just ask InterMune's shareholders after it fell from the sky last month.

Should you avoid these drugmakers because they have lofty valuations but have yet to prove themselves? Maybe; I am. If you do decide to invest, make sure you know what you're getting yourself into and aren't blindly following the crowd.

Vertex is a Motley Fool Rule Breakers selection. The newsletter's team is always on the hunt for hot drug stocks and other cutting-edge picks. See all of our latest discoveries with a free 30-day trial. 

Fool contributor Brian Orelli, Ph.D., doesn't own shares of any company mentioned in this article. Novartis is a Global Gains selection. The Fool has a disclosure policy.