Valuing biotech stocks
Before investing in Biotechnology companies it is important to have a clear understanding of the risks of investing in high-tech/high growth sectors, but also of the value determining factors for companies in the sector.
As with any investment* ASX recommends that you seek professional advice to ensure that you understand the nature of the investment and whether the investment is appropriate to your particular circumstances and financial needs. There are a growing number of advisory firms that are taking a specific interest in the Biotechnology sector and they produce research and are developing significant expertise in assessing and valuing ASX listed Biotechnology companies.
Within the Biotechnology sector there is a considerable range of risk profiles among the companies. Levels of risk are determined by a number of factors including the nature of the company's technology, product or service and its stage of development. Companies within the sector broadly fall into three groups: drug discovery, pharmaceuticals, and medical devices and diagnostics. Valuation and risk assessment may differ depending on the group in which a company falls. For example investment in a medical device R&D company may carry lower investment risk than a drug discovery company because of the more complex regulatory hurdles, long lead times, and uncertain sales potential associated with drug discovery and commercialisation. With this higher risk goes higher potential reward
On the other hand, there is considerable diversity within the sub-groups making it difficult to generalise about risk assessment and valuation. Some companies are at a very early stage of development, facing long lead times before there can be any prospect of commercialisation of their technology. They have negative cash flow and are reliant on patient investors for continued funding to achieve their goals. At the other end of the spectrum are companies that have successfully commercialised product, have positive cash flow and can be valued using conventional valuation methods. Some companies have a portfolio of products and potential products at various stages of development and revenue earning capacity.
This guide is a basic description of some of the things to look out for when looking at Biotechnology companies and is generally applicable to companies in the earlier stages of development. It should not be considered to be a comprehensive guide, and investors are again advised to undertake detailed research of individual companies' activities and prospects and to seek professional advice before investing.
Points to consider when valuing biotech companies include:
- Stage of development: Assess what stage of development the company is at in order to estimate the time frame in which earnings can be expected. The process to commercialisation can be long - the development of a successful new drug can take many years from the first stages through to distribution. Companies with a drug candidate in late stage clinical trials would be expected to earn revenue sooner than a company with drugs in the early stages of development. This does not mean that later stage companies are necessarily better investments over the longer term - they are just closer to generating income and so are probably less risky.
- Product pipeline: Look at how many products the company has in development. A company that diversifies across a range of product types will be less volatile than a company with only one product in the pipeline. Companies that have a spread of drug candidates through each trial stage are probably less risky.
- Cash reserves: Early stage biotech companies can consume large amounts of capital for research and development, and may not report earnings for a number of years. For this reason it is important to look at whether the company has adequate cash reserves.
- Quality research and development: Understanding the research activities and results of a biotech company can be difficult. Some factors that may indicate quality research and development include the award of government R&D grants, investment in the company by venture capitalists and interest in the company from industry specialists. Look at the reputation of the scientists involved, and for collaborations with respected research institutions.
- Regulatory considerations: Look at the type of biotechnology company and its products. Regulatory approval time will vary according to the type of product. Regulatory approval for devices and equipment in the healthcare sector is swifter than approval for prescription drugs.
- Intellectual property: Biotech companies protect their technology with patents. Much of the value of a biotech company comes from the knowledge contained in their patents and staff. Patents for new drugs and therapeutic products give the owner the right to exclusive exploitation for a period of 20 years. When the patent for a prescription drug expires, other companies are allowed to begin production of that product.
- Platform technology: Platform technology has the potential to yield a range of many different drug candidates, as opposed to a technology that yields only a single or limited amount of products. Assess whether a company has platform technology, as it is generally more valuable and less volatile.
- Markets: Think about what disease the company’s products are targeting. Look to see whether there are existing drugs to treat the disease, and what the estimated demand for the new drugs would be.
- Senior management and other key staff: Look at whether the management of the company has a good track record in delivering successful research milestones. It is also important to consider the commercialisation strategy of the company and the quality of scientific advisers. Strong financial management is vital given the early cash burning nature of biotech companies.
- Clinical trials: Monitor the results of clinical trials to see how the drug/product performed.
* The information contained in this guide is for educational purposes only and does not constitute financial advice.