real options

Hi folks,

General question: what do people think of real options valuation? I don’t know if this is a widely known method but it is laid out in Boris Bogdan’s book ‘Valuation in Life Sciences: A Practical Guide’. I’m slogging through the book but it seems to boil down to discounted cash flow with probablities of sucess built in and an option to ditch things that fail (so the value is zero not negative). This makes sense to me and the venerable discounted cash flow seems poorly suited to small biotech companies that are years from their first sale and make huge valuation changes overnight when they announce a clinical trial result.

However, I’m brand new and I may be missing something so my question is: am I investing time in learning one oddball’s pet theory or is this a respected technique with credibility in the field (at least the field of biotech)?



DCF is clearly a poor choice for a small biotech. That should be pretty obvious. Anytime where you have massive terminal value locked up like that, the model becomes far too sensitive to be realistic Though oddly enough many clients still want to see it done regardless

Biotech is one of the few industries that I almost never look at (except once a year on the short side), so take this with a grain of salt.

Biotech stocks are among the least efficiently priced in the market because of the binary nature of the outcome (usually). Typically a probability valuation is used instead of a DCF approach. You might look at the estimated size of market for a drug with a range of estimates for how much penetration (if green field) or market share (if planning to enter against incumbents) the company’s drug or product could achieve. The actual profitability of the company is less important than the sales figure (because most companies get sold if they have a winning drug, and then become part of larger, more efficient operating structures). So a multiple of sales of based on the estimated potential sales of the drug is appropriate.

If, for example, you think that the potential size of market is $100M and there is a 50% chance the drug catches on, the upside market cap would be $50M (100 * 50% + 0 * 50%) – assuming the stock is worthless if the drug never catches on. You would, of course, adjust that for the cash on hand (as a function of the estimated burn rate). I don’t really see people discounting the forecast back because the probability is sort of an all encompassing discount rate anyway.

So as you can see, there could be a huge range of value, and that’s one of the reasons the stocks are so volatile. I am not really sure how anyone estimates the probabilty part of the equation since they always seem like long shots to me, but obviously it depends on what stage the drug is in and a bunch of other factors. There are some really crazy sophisticated hedge funds that hire independent medical teams and consultants (and probably pay people for inside info as well) that try to derive an edge that way – you and I probably don’t stand a chance, and you are probably better off focus on operating companies instead of R&D companies if your goal is to learn how to invest.

But if your question is, do real options have value? Then the answer is definitely yes, and that comes up across many industries / situations. I tend to just estimate the impact of the option on the company’s fundamentals and igore any esoteric models or whatever (most people don’t ever look at that stuff).

The problem with evaluating biotechs isn’t just one of probabilities. There are biostaticians and Cheif Sciencists that have little better idea whether their drug is going to pass phase 3 than you or I. FDA can be somewhat inconsistent in their methods application and with the pace of medical science (not to mention lobbying) new rules are created all the time. To be at all skilled in this area, you need a background in both FDA and pharma (policy and research) and undertand the industry implications.

Probability is the method, but you’ll lose your shirt unless you have the experience/knowledge to apply the correct probabilities. Kind of obvious I guess, but I have spoke to chief scientists who told me they have no idea what will happen with the trials most of the time…the younger guys think they do, but probably have a low hit rate.

Yes of course. The probabilities are pretty arbitrary but that’s how it’s done. I think it’s a fool’s game.

regarding the specific question from the OP: real options is definitely not an insignificant pet theory and has many diverse applications. definitely worthwhile to study.

i am not so sure that valuation of biotechs is the best application of this technique however. as other posters mentioned, the valuation of a biotech is very complex and depends on the stage of clinical development of each drug in the portfolio, amount of subsequent funding required and probability of success of clinical trials, chance of FDA approval and drug commericalization, patent protections and presence of branded/generic competitors, R&D pipeline… it lends itself to probabilistic decision-tree type analysis, but more so case-by-case specific analysis of possible binary outcomes than just fitting some probability distribution.

i’ve seen real option applications in energy, metals & mining industries - it seems a lot more appropriate and theoretically justified to apply real option techniques in these sectors