VIEW: Real option valuation in biotech
Real Options is still not widely accepted in the Bio-Pharmaceutical Industry for various reasons such as their complexity, novel concept, and inability to be recognized in real-life managerial settings.
Let’s assume that a biotech company has developed a patent for a cancer therapeutic compound that targets a specific apoptotic-inducing mechanism and would like to value the patent. Should the patent be valued using options, discounted cash flows, or both?
Real options are never a substitute of discounted cash flows but rather a complement to it. It depends on what stage the project is. A project with very high uncertainty and risk has more an option value and less DCF value and vice versa. For example- If the drug is at early stage such as under pre-clinical, it has less DCF ( discount rate used will be very high) and higher option value ( due to higher uncertainty) than a drug which has crossed Phase III and is waiting for regulatory approval and registration.
So, when are Options really valuable? Let us focus on just one reason today
Exclusivity: Does your patent provide you exclusivity for the stated period? You might be wondering why such a trivial question. It is obvious that the patent implies that company has the rights to develop the product. However, the patent does not protect other companies from developing another drug that interacts with the same targeted mechanism via a different pathway. Assuming your competition also files a patent for the same target. In that scenario, you do not have full exclusivity. In other words, you have limited exclusivity up to a certain period and your option value may be less. The more competitors you have, the more chances are there for having the drug for same indication and more chances that the life of the exclusivity (that you could have enjoyed provided you are the only one developing it) will decrease.
Hence, managers should take caution while valuing the products at early stage.