The perils of rule of thumb in biotech valuation
Despite the fact that Valuation is subjective, there cannot be any argument on tweaking the fundamentals of Valuation – risk, growth and cash flows based on rules of thumb. That said, one could see many valuation reports floating around with the ‘rule of thumb’ assumptions in valuation.
One of the widely used ‘rule of thumb’ assumptions is the discount rates.
Discount rates: When we value an asset or product, we estimate the future cash flows. The future cash flows are uncertain and one of the ways to capture that uncertainty is the discount rate. Practically, we expect to put higher discount rates for risky projects and lower for less risky projects. However, there are many parameters, if not used correctly, will lead to wrong discount rates.
For example- If a biotech company has a finished product and is interested to launch the products in different markets. The discount rates would be different for each set of cash flows received from different countries due to varying risk premiums for each country.
It is interesting to note that in many articles on biotech valuation or valuation report by a consultant; a range of 20%-26% discount rate is used to value a biotech product at an advanced stage or even when it is fully developed and ready to be commercialized. There are two arguments used to justify this:
– It is very difficult to calculate the discount rate of a project/product
– This range of discount rates are widely used by managers in pharmaceutical industry to value their products
We disagree with this notion. Each asset or product has to be dealt separately and the argument that it is very difficult to find out the discount rate because the project is unique is not relevant. Given that argument, it would be difficult to value companies such as Microsoft or Apple as they have unique products.
Another interesting fundamental which is widely misunderstood is the risk of the cash flows. Are the future cash flows dependent on you if you decide to out license your product? In one of our earlier posts, we argued that if we out license our product to a company X, the risks associated with our cash flows are dependent on company X and not based on our hurdle rate.
Hence, the managers at biotech firms should be careful in assessing the valuation report and understand the following:
- Have the valuation experts used the right discount rates? What measures they have used in getting the discount rate
- Have they double counted the risk? If the experts have “risk adjusted” the cash flows using the probabilities of getting the cash flows in future, that uncertainty should not be counted again by increasing the discount rates just because the project is perceived to be risky
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– Saurabh Mishra