How Do You Value Biotech Stocks?

<p>It's often said that biotech stocks trade on binary events, such as public disclosures of clinical trial data or regulatory approvals. That's true to some extent, but there's a bit more nuance for investors to consider.</p> <p>Pre-commercial drug developers don't have recurring revenue, earnings, or operating cash flow to interrogate when determining fair value, which forces Wall Street analysts and savvy investors to lean on other valuation tools. Net present value (NPV) and risk-adjusted net present value (rNPV) models can be built to account for the lack of traditional financial fundamentals and the high-risk nature of drug development. Although imperfect, these tools provide a rough, quantitative tool to properly value drug assets.</p> <p>For example, rNPV models can estimate the probability of success (POS) that a drug candidate in a phase 1 clinical trial will reach the market. That percentage can then be slapped onto future expected cash flows and adjusted for the time value of money to determine what the asset might be worth right now. Of course, no one knows the true POS of any single drug candidate. Wall Street analysts often plug in historical averages for specific therapeutic modalities (ex: monoclonal antibodies or kinase inhibitors) in specific therapeutic areas (ex: oncology or neurology).</p> <p>This modeling imperfection and crude estimation is what causes the perception of binary events. When a biotech stock craters or soars on a clinical data readout, it's often because Wall Street models are being updated all at once. Similarly, when a large drug developer pays a hefty premium to acquire a smaller peer, it's often because they're applying a much higher POS to the pipeline being acquired -- likely due to a deeper technical understanding of the science involved.</p> <p>In other words, there's a tremendous amount of value residing in POS differentials. If investors can build relatively accurate rNPV models that incorporate a technical understanding of the underlying drug candidates, then they