Guide To Evaluate a Biotech Company

GrandJury's picture
Rank: Neanderthal | 2,048

I am currently a research analyst intern at a relatively decent sized hedge fund. One of my responsibilities is being in charge of the biotech stocks in the portfolio as well as researching new opportunities in the biotech sector. Hopefully this helps some people who are in need of some help whether it's pitching a stock for an interview or just for personal investing. There is big money to be made in the biotech sector.

Evaluating biotech companies to invest in cannot be done in the conventional way (i.e using common metrics such as P/E, Revenue,etc.) A biotechl company, especially a small one, has little to no revenue and earnings. Does this make the company crap? No, because all these companies are focused on research and development. Instead, there are three main keys to focus on while looking at a bio-pharmaceutical company.

1) Cash
2) Catalysts
3) Pipeline Potential

The first key point is cash. How much cash does the company have on hand? When was the last time they diluted their shares? How long can they last with the current cash they have on hand? How do they receive cash (i.e. by partnership, outside institutional funding, issuing more shares)?

Cash is the lifeblood of biotech companies. Without cash, they cannot fund their testing and trials which means that the company is doomed for failure.

The next key point is catalysts. What are some predicted events that will shift the stock price in a positive way? Is it the announcement of a trial that will be concluded? Is a new management team being hired? Did the quarterly financial results beat the expected data?

Catalysts are a huge attribute to biotech companies. That is how money is made and lost when investing in biotech.

Ex. A certain company is in the midst of their Phase IV trial. The trial is suppose to conclude at the end of Quarter 2 in 2013. If you expect the results to be favorable, that would be a catalyst for the stock price.

The last major key point is pipeline potential. The pipeline is all the company's drugs that they either have on the market and/or are currently testing. A diversified, well-rounded pipeline is favorable. When one speculative company only has one drug in their pipeline, it is incredibly risky to investors because if that drug is unsuccessful, then the company is at risk of completely failing.

To put this into action, let's do a quick evaluation of Celsion Corporation (CLSN).

First, let's look at their cash situation. At the end of Q3 in 2012, they had a total of $23m in cash & equivalents. In addition to this $23m, Oxford and Horizon has promised to fund $5m to CLSN if their HEAT study trial, which will be completed at the end of January, shows positive results.

Management has directly stated that the current cash is sufficient to last until the end of 2013 and no dilution will be issued until at least after the results of the HEAT study trial is out.

So for CLSN, cash situation looks fine.

Second, let's look at some short-term catalysts. The major one will be the announcement of their HEAT study trial results at the end of January. Many investors are optimistic about the results and investors have often seen biotech share prices increase as much as 200% after a successful announcement of testing.

Last, let's look at their pipeline. ThermoDox is the drug that they are currently performing tests on. However, ThermoDox is believed by Celsion to be able to treat multiple types of diseases. ThermoDox is on the verge of treating liver cancer, and is being tested for the treatment of breast cancer, and colorectal liver mets.

Due to this quick evaluation, one can see how to generally evaluate a biotech company.

Hopefully this has helped. If you have any questions or comments feel free to ask/share.

Comments (76)

Jan 8, 2013

Here is your free beer bro ;D Greatly Appreciate your effort in putting this thread together.

*It would be great if someone can do a Guide To Research/Evaluate E&P Company. thanks

Jan 8, 2013

nice quick summary. I'm interested in how you can evaluate the potential success of trials and what not with insiders info. I assume you would hire an industry expert such as some Biochem PHD who can break down the secret sauce and analyze it.

Jan 8, 2013

Great post. If you haven't already, check this out: http://www.amazon.com/Biotech-Trader-Handbook-2nd-....

Jan 8, 2013

To piggyback on what ladubs111 said, I am rather unclear how non-PhDs can research and evaluate biotech stocks without understanding the science.

Jan 8, 2013
ladubs111:

nice quick summary. I'm interested in how you can evaluate the potential success of trials and what not with insiders info. I assume you would hire an industry expert such as some Biochem PHD who can break down the secret sauce and analyze it.

Amphipathic:

To piggyback on what ladubs111 said, I am rather unclear how non-PhDs can research and evaluate biotech stocks without understanding the science.

Generally there will be access to professionals who understand the science of it all since most if not all finance people have no idea about biotechnology itself.

I actually use a lot of outside sources to help give me an idea of trial. Other factors such as recent partnerships, outside funding, insider buying, and other drugs in their pipeline being successful all attribute to more increased confidence in a company and their drug testing.

Since analyzing biotech companies is difficult in the sense that we don't understand the science behind their products, it is a big risk factor but also has unlimited profit potential.

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Jan 8, 2013

why your fund would hire someone with no science background to analyze bio stocks is beyond me

Jan 8, 2013
BigHedgeHog:

why your fund would hire someone with no science background to analyze bio stocks is beyond me

Even with a science background the people that can analyze this shit is like 10 year industry experienced PHD from Amgen, Baxter, etc. Its way beyond a normal PHD graduate. I have a STEM background and I could not tell you why the fuck the Dreamliner keeps on catching on fire.

Jan 8, 2013
ladubs111:

I have a STEM background and I could not tell you why the fuck the Dreamliner keeps on catching on fire.

Maybe it's flammable.

Jan 8, 2013
BigHedgeHog:

why your fund would hire someone with no science background to analyze bio stocks is beyond me

Yeah I'm really not getting it. Love to know which funds do this so I could be taking the other side of their trades.

Sep 27, 2014

I actually thought this myself until doing some research in the space. Bottom line is, smart people figure shit out. Hence reading comprehension sections in any standardized test will include dense science passages which assume absolutely zero background knowledge. Perhaps the greatest biotech investor of all time is Randall Kirk...a JD from UVA.

Jan 8, 2013

For biotech do you perform NPV analysis on these pipelines and at which stages and create a DCF valuation?

Sep 27, 2014

I would not pitch a biotech company unless you truly understand the science behind their products. Similarly, if you are pitching to a team with biotech coverage they will likely eat you alive

Jan 8, 2013

I'll chime on here, but I have to be a little careful what I say.....

I saw this headline and thought "interesting, but how the hell is this WSO poster going to teach us to value science". What he says is 100% true, but the only thing that matters is the pipeline potential. While worrying about burning through cash is real, if the potential is even reasonable the company will get the cash.

What I'll tell you is that it's not realistic to value the potential of an early stage drug. All you can do is make estimates at parameters of the value of the drug and of the costs to develop (side note - I think I remember reading that it now takes on average $1B for big pharma to fully develop and market a drug). Even the companies developing the drugs probably don't have accurate values of what the drug will be.

I agree with BigHedge in that I assumed most funds would hire science or engineering backgrounds for this type of position, but ladubs is also right - no entry level employee is going to get it right.

This really just boils down to risk tolerance vs. reward. As an outsider, I avoid small biotechs because my investment might go up 500% in the next 3 years if successful Phase 2 and Phase 3 testing is complete, but I really have no idea if either will be successful. Of course management will tell you they like their chances, but that management speak isn't good enough for my $.

twitter: @CorpFin_Guy

Jan 9, 2013

Hi everyone, I'm new here to this site and just perusing somewhat. I saw this post and it looked interesting so I would just like to add some comments. I've been around for a while, teach finance and am a CFA charterholder, but not a biotech expert by any means - though my general knowledge is respectable enough I suppose. Sometimes I question my expertise in everything...:)

I have invested in biotech/pharma stocks and tend to stay away from them in general, but once in a while invest What I've learned is that it is not always good or bad science that determines the ultimate value, but the FDA, a government (and thus political) organization. I have seen good science, confirmed by independent industry experts, go nowhere, and we've all seen crap get approved.

I disagree that you have to be scientist to properly analyze a biotech stock. Mainly because there are many other factors that determine value than the underlying science. Like what the market thinks about the science. For public companies, determining "value" relative to a stock price is easier than determining it from scratch.

Also, from what I've seen, the real options approach has largely replaced DCF as the model of choice. Since approval/no approval is a binary outcome, it makes sense.

Cheers

Jan 12, 2013
rdlgeo:

Hi everyone, I'm new here to this site and just perusing somewhat. I saw this post and it looked interesting so I would just like to add some comments. I've been around for a while, teach finance and am a CFA charterholder, but not a biotech expert by any means - though my general knowledge is respectable enough I suppose. Sometimes I question my expertise in everything...:)

I have invested in biotech/pharma stocks and tend to stay away from them in general, but once in a while invest What I've learned is that it is not always good or bad science that determines the ultimate value, but the FDA, a government (and thus political) organization. I have seen good science, confirmed by independent industry experts, go nowhere, and we've all seen crap get approved.

I disagree that you have to be scientist to properly analyze a biotech stock. Mainly because there are many other factors that determine value than the underlying science. Like what the market thinks about the science. For public companies, determining "value" relative to a stock price is easier than determining it from scratch.

Also, from what I've seen, the real options approach has largely replaced DCF as the model of choice. Since approval/no approval is a binary outcome, it makes sense.

Cheers

this is absolutely correct! biotech companies are still businesses and there are plenty of other normal business factors to consider.

However, you'll never understand the FDA process fully until you've followed a couple. Drug approval isn't just a simple checklist and sometimes you'll see great products get denied for some stupid reason. Now the company needs a ridiculous amount of cash and will have to dilute shareholders by accepting capital from some greedy PE firm. Marketing, distribution, shareholder friendliness, CEO experience are other things you can base valuation on.

The key here is to know everything about the FDA and how much management knows about the FDA

    • 1
Sep 27, 2014

You can apply multiples (usually revenue or EBITDAR with the R being R&D) at various stages of the drug approval process (FDA Phase I,II,III and so forth), using different multiples for different phases based on comps

Jan 8, 2013

You don't have to be an M.D. to evaluate the statistical significance of trial data. Looking at past PDUFA decisions by the FDA for similar drugs can give a lot of insight into the potential for success.

    • 1
Sep 27, 2014

I like Alnylam (ALNY), their delivery platform is unmatched. And they have great stuff on the way...
And Achillion (ACHN), I think they have one of the more promising hcv drugs, ACH-1625. HCV is a tricky market, but I like its profile best compared to gilieads or vertex's (even though I'm still bullish on vertex after the immense pullback.

Sep 27, 2014

Is the pitch all based on fundamental or technical too?

Sep 27, 2014

Try Organovo (ONVO). Small cap but has an innovative product/service with strong revenue growth prospects, partnerships with pharm giants and universities, and intellectual property protection. Also up 10% today.

Sep 27, 2014

.

Sep 27, 2014

ACAD
ARNA
CLSN
OREX
TSPT

Jan 8, 2013

I think some analysts use a certain type of DCF to determine the amount per share that the medicine (or similar) represents, I once owned a small biotech in Belgium (they tend to have a lot biotech potentials these days) and when a certain phase was not passed analysts revalued the stock from 12 to 9, saying that the medicine would have earned 3 a share if it had been released.

How do they do compute this? No clue, and I can hardly believe that any nonscience (be it academic or recreational) guy can derive it.

Sep 27, 2014

What is general sell side research? Didn't you cover an industry or sector at a broker-dealer?

Sometimes sell side shops for biotech like people who have worked in the industry for a few years. So, if you worked at Pfizer or some specialty pharma, that's valuable. Try for a healthcare role in the industry, an MBA doesn't help for ER.

Jan 9, 2013

the biotech sector is probably the most corrupted sector to trade in.

you have the understand the ceos have the fda in their pockets and only a few pharm industries get fda approval let alone make it to phase 3

most companies are inside traded pump and dumps schemes with monkeys for management.

    • 1
Sep 27, 2014

Bump - would appreciate this too!

Sep 27, 2014

If you search carefully you can find links to a couple of older models.

I've found more than 10 from links posts.

Jan 10, 2013

Interesting read, thanks for posting.

Sep 27, 2014

If the money was spent, its gone. Can't undue that. So it's a sunk cost and isn't factored into your current analysis. If you had done this before they spent the money on R&D then you would factor in that spending as a capital expenditure. I'm not entirely familiar with biotech valuation so there could be some differences due to the high levels of R&D. Second highest percent of revenues spent on R&D, industry wise. So you may have to account for frequent R&D expenses

Sep 27, 2014
mjp_1010:

Hi WSO,
Shouldn't the accumulated deficit and low cash levels of the company make a difference? Should I not take the future value of the past R&D cash outflows and bring them up to the present?

No offense, but I think you might be overthinking it with questions like that.

Simply put, as another poster mentioned, the past R&D spend is gone and you don't need to worry about it anymore. However, as you rightly recognize, that's not entirely worthless because you now have significant NOLs. You just have to be able to correctly model out how they'll impact your future cash taxes and you should be on your way. As a heads-up, if the company is still in phase II, you'll likely continue to accumulate significant NOLs until the product launches so make sure to model that out correctly as well.

Aside from that, it should be like any other DCF after probability adjusting certain cash flows.

Sep 27, 2014

"Taking the argument to the extreme, not taking past history into account would value equally the same company with the same estimated future 1) if it had extremely high cash levels and retained earnings, or 2) none at all."

Just wanted to address this part.
1) You need to make the distinction between an accounting concept (net income and retained earnings) and a finance concept (free cash flow). A high retained earnings account (i.e. positive accumulated income) does not equate to a high (or even positive) accumulated cash flow (specifically, cash flow derived from operations). However, a net loss for an early stage biotech company probably also relates to a negative cash flow (and thus, high cash burn rate and decreasing cash balance on the b/s).
2) Now, let's think about DCF. In DCF, you estimate the INTRINSIC value (i.e. the whole company, regardless of financial structure). And such value is derived from FCFs going forward (i.e. if I was an investor of the company today, I only care about what I will receive going forward). Now, you also take the NOLs into account because NOLs have a future value through the carry forward rule.

Now, where does the cash levels come in? Remember the difference between enterprise value and equity value? Basically, before you get to your share calculations, you should get to the equity value from the EV derived from DCF by subtracting total debt and adding cash & cash equivalents. Think about buying an apple tree. You have dips not only on the future apples the tree will produce but also on the apples hanging on the trees right now.

    • 1
Sep 27, 2014

Is a Risk Adjusted DCF the only option or are you choosing to do it? I think there is an easier/better way of valuing a pre-revenue biotech.

Sep 27, 2014

I'm choosing to do it. Interesting, I thought rNPV was standard - what's your other method?

Sep 27, 2014

Capitalize that R&D Bish!

Sep 27, 2014

Reasoning? :)

Jan 12, 2013

Thanks for posting. Being a major in biotech and having interned in a pharmaceutical company, I found the reading very interesting. I think that the biotech/pharmaceutical business is one of the most complex to understand, and certainly there are multiple factors to consider which can have a crucial impact.

Sep 27, 2014

I'm also interested in this.

Sep 27, 2014

I'd like to bump this. Anyone have any recommendations?

Sep 27, 2014

I am something of a novice but maybe you'll find what I have to say interesting.

I've been trading/investing in biotech for about 1.5 years and have had some success - I don't remember the book I first read but I happened upon it by chance at my University's Co-op/bookstore. It was required reading for some Pharm/bioengineering class. It talked extensively about the financing challenged faced by clinical pharmaceuticals.

I think their may be some value in examining the financing cycle - e.g. Find the average expected burn rate (how fast the company eats through its cash) and the expected length of the current research/trial phase. I find that as the anticipated catalyst approaches, share price tends to rise. And since it is difficult for clinical stage bio to raise debt, additional financing is generally dilutive.

This is only for smaller "baby" biotech companies...

Looking for a Finance Job - currently unemployed.

Best Response
Jan 21, 2013

NPV analysis is really the only way for a biotech.

First, establish the probability of launch (generally by looking at previous launches - e.g. targeted antibodies for cancer with good early Phase 1/2 tolerability/toxicity are generally more likely to be successful compared to a drug targeting multiple organ systems such as in sepsis (noting in decades except a withdrawal by FDA), or complex less well fundamentally understood areas of science like neuroscience) or just use "standard" Phase 1/2/3 probabilities, 20%, 40%, 60%.

Second, look at managements guidance and clinicaltrials for expected launch year and then build a peak sales estimate based on time to peak sales and height of peak sales using things like diffusion models and decision trees. Or just use the standard 5 years after launch argument or compare to similar products - e.g. Novartis' Gilenya/Sanofi's Aubagio when looking at Biogen's BG-12

Third, Assume a sales plateau period consisting of incremental price rises and estimates of NRx versus switches and new competitors entering (Zytiga and Xtandi in a few years)... generally plateau when growth slows to below discount rate - generally 10%-20% for biotech). This lasts until patent expiry (e.g as in FDA Orange book).

Estimate an operating margin for each product - very rarely given but often given COGS for a division/segment (e.g Speciality Pharma or Interventional medicine or Cardiovascular EBIT). Probably best to use post-tax pre-R&D margins. Also look at competitive environment as some drugs (e.g. statins/medical devices) may require large sales forces thus >SG&A.

Patent expiry...ummm, what region is the product going off patent in (US/EU/Japan), is it a biologic/white pill, exclusivity/paediactric extensions, authorised generics (e.g, Shire/Impax in aDHD) or straight pure generics, how is it taken/administered (e.g. Advair/Seretides inhaler), what has happened when previous same class drugs have lost patent protection (e.g. Zocor-Lipitor-Crestor).

Obviously other factors to consider too but that should be a start - let me know if i have missed anything important...

    • 2
Sep 27, 2014

Upper level classes in undergrad? None that I've ever heard of...

Just read the books. My favorite is The Biotech Investor's Bible, George Wolff knows his stuff.

Sep 27, 2014

K thanks. As an undergraduate yes. I'm talking about like biology classes. I'm minoring in biology and I want to try fill in some things that can be helpful in the biotech/pharm sector

Sep 27, 2014

Tough sector.

Sep 27, 2014

hey man, i graduated with a bio degree, worked in medical research for a few years and am now at a ER shop. I can tell you that immunology, microbiology, organic chemistry classes are very useful...however, remember, the biotech industry will only usually provide clinical results, which can you read if they publish the full clinical data in a journal...but I doubt it would help with your investing purposes...I would advise just understanding the gist of what some biotech companies currently produce (what they target), their pipeline, and future pipeline. Understand the FDA process, as approvals rely upon that.

Hope this helps.

    • 1
Sep 27, 2014

Thanks a lot guys! derpherp do you mind if i PM you about classes?

Sep 27, 2014

that can be helpful in the biotech/pharm sector

Then you need to define what your subject means by "Biotech Investing", as potentially defined by either of the following:

Public Market Investing (Trading) - Nothing upper level science classes will tell you will be useful. At this level, investing is primarily based on statistics (and some basic biology). I don't give two shits if a company comes out with a fancy name called "troponin activator for ALS", if it's clinically ineffective in it's phase I/IIa/IIb/III trial, based on statistical significance and trial design, it's ineffective, period... (i.e. see recent clinical data from Cytokinetics)

Venture Capital (Early Stage) - Upper level classes will be useful for this area, but you don't need to dive deep like the PhD prospects do... Having a basic understanding of Biochemistry and Molecular Biology will suffice; mechanisms in those areas of science are fundamental constraints in all areas of biological study. You will be able to understand the mechanism of potential therapeutics in the pre-clinical environment, that can translate to post-IND human clinical trials.

Sep 27, 2014

Biotechnology Valuation by Karl Keegan, all you will ever need to know.

Sep 27, 2014

Thanks man! Does anyone by chance have a PDF version?

Sep 27, 2014

Howdy! Any market cap restrictions?

Sep 27, 2014

Happy to help out. It's easier if you PMed tickers. Are you with a hedge fund or a venture firm?

Sep 27, 2014

No cap restrictions so long as the product is pre market. Looking for public companies preferably but companies looking for VC funding as well would be lovely, thanks.

"...all truth passes through three stages. First, it is ridiculed. Second, it is violently opposed. Third, it is accepted as being self-evident."

  • Schopenhauer
Sep 27, 2014
seabird:

No cap restrictions so long as the product is pre market. Looking for public companies preferably but companies looking for VC funding as well would be lovely, thanks.

I can send you some, just let me know where to send.

Sep 27, 2014

I'm interning at a hedge fund currently and I am responsible for the 30+ biotech stocks in the portfolio. I'd be happy to set you off on the right track. Just hit me up.

Sep 27, 2014

PMd u in the butt

Sep 27, 2014

Wondering the same. The company in question in a startup biotech firm without any revenues, but will produce some in the near future. How would I perform a DCF analysis? To calculate the terminal value, I would use a comparable company's multiple, but which multiple would I use? Thanks.

Sep 27, 2014

Comparable comps bros

Sep 27, 2014
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