Valuation of an R&D stage pharmaceutical drug: what are the key value drivers?

The development of a pharmaceutical drug takes on average 10.5 years[1] with average costs of development ranging from $314mio to $2.8billion[2].Every time during those development years, when money has to be spent on the development process, typically the following questions come up:

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> What is the current value of this drug now given its development stage?

> What will the value be if we bring it successfully to the market?

> How much time, effort and money needs to be invested to bring it to the market?

> What is the expected return on the investment if we invest the money in further development?

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Valuation and decision making framework

For answering the above questions, the Risk Adjusted Net Present Value (rNPV) methodology is the golden standard in the biopharma industry and commonly used to calculate the current and future intrinsic value  of a drug in development.

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In this article, we will dive deeper into:

1. The rNPV method

2. The fundamental value drivers

3. Limitations of the rNPV method

4. The insights created by the method and how these can be used to optimize R&D value creation

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Performing a rNPV exercise will not only provide a value number at a given point in time but also generate insights that allow for more informed strategic investment decisions.

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[1] 2021 clinical success ratesBIO/Informa/QLS

[2] |O.J Wouters et all, JAMA. 2020;323(9):844-853

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The rNPV method

The RiskAdjusted Net Present Value (rNPV) method is a financial analysis technique usedto evaluate the potential value and IRR of an investment in a biotech or pharmaproduct in development. The difference with a regular Net Present Valueanalysis is that the risks associated with the (pre-)clinical development processof a biopharmaceutical the product are taking into account.

The rNPVapproach involves 3 main fundamental value drivers:

> Time

> Future cash flows

> Risks‍

These 3 main value drivers can be seen as  “Vectors” that influence the curve of future cash flows in a graph.

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These 3 main Vectors are the sum of sub-vectors that influence the main vectors.

Forexample, if we look at the vector TIME which dictates the width of the curves below and above the line is built up out of several sub-vectors such as:

- IP protection period,

- clinical development pathway

- approval times

- launch period etc.

Hence, in order to get a grip of the 3 vectors, all sub-vectors have to be assessed and estimated for the particular asset. For the rNPV method to generate a correct intrinsic value and reliable insights these sub-vectors need to be underpinned with asset specific intelligence that is benchmarked against industry data.    

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The Fundamental Value Drivers

First Vector: Time

The first vector that needs to be analyzed is the element of Time, as all future cash flows(positive and negative) need to be discounted for the value of time to get to the current (net present) value.

For a biotech or pharma product in development the element of time can be broken downinto 2 stages.

The first period is the pre-market Development Time: this is the time from inception/invention ofthe drug till the moment it gets approved.

The second stage is the Sales Time: this is the period the drug can be sold exclusively on the market (i.e. fromlaunch date till patent / data exclusivity expiry) in a specific territory and cangenerate positive net revenues.  

Typically,the overall time a biotech or pharma product can generate (significant)revenues is limited due to the fact that once market protection ends – as the patent life or data exclusivity runs out – competitors selling generic products against lower pricing will decrease the market share significantly.

Given there is only a limited time to generate positive net revenues (in the second stage), it is crucial to limit the Development time as much as possible to preserve the drugs value potential. Every additional month it takes to get a product developed and approved by a country’s regulatory agency (e.g. FDA or EMA), the further out the ability to generate positive cash flow will be. Conversely, the quicker a product is approved, the faster and typically longer – due to market protection – a product can generate revenues, which has a big positive effecton the value.

The timevector is therefore a double-edged knife that has the most profound effect on the value potential of a drug in development. Therefore, any strategic decision around the development of a new pharmaceutical drug has to be taken within this context to ensure the maximum IRR of the R&D efforts performed.  Examples of decision that can be taken to optimize the time vector are: obtaining orphan designation, fast track approval, obtaining a priority review voucher, or opening multiple sites indifferent geographies to fasten trial enrollment. All of these types of actions will have a positive impact on the value of the drug. Typically, the additional revenues generated by having a product faster on the market massively outweigh the additional costs required to optimize the development plans and shorten lead times to approval (hence creating a higher IRR).

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Second Vector: Future Cash Flow (FCF)

The second vector that determines the value of an asset under the rNPV methodology is the analysis of the composition of the future cash flows.

Negative cash flows first

When developing a new biotech or pharma product the period up to market approval of the product typically is a period of negative FCF generation due to the fact that only development and associated cost are made in order to get the product through the clinical trials. There are no ways for the asset to generate positive cash flows until approval[1].

Given that the development costs need to be made early in the FCF life cycle and are therefore only modestly discounted, these negative FCFs have a relatively sizeable impact on the overall rNPV for a drug prior to approval.

Therefore,it is also important to assess if the development plans can be optimized from acost perspective to reduce this impact. For the design of clinical trials this means that developing companies constantly strive to find the right balance between incurring costs and expediting the development timelines. Modelling the various scenarios using the rNPV method is typically a worthwhile effort to get this trade-off right and ensuring maximum value creation. Other ways to optimize the negative cash flows can be the outsourcing of non-core activities and avoiding large cash outflows such as capital expenditure in the form of facilities and equipment (which are rented instead).

Positive cash flows second

Getting aproduct approved, starting to treat patients and generate revenues is of course what the overall goal is when developing a pharmaceutical product. The generated positive cash flows form the anchor from a financial perspective of every drug development project. However, estimating the size of the positive Future Cash Flow is one of the most difficult parts of the entire valuation exercise.

The foundation of the assessments of the future revenue potential is the Target Product Profile (TPP) of a drug in development. This profile encompasses, the intended indication, use, route of administration, dosing etc. This profile should be compared with the current Standard of Care to see what attributes of the new drug justify the use of this new drug over the existing Standard of Care treatments. Subsequently, the same exercise should be done with potential competitors that are in development. Ideally, this assessment leads to the recognition of unique selling points of the new drug that would ensure future market demand. Subsequently, it should be determined what these USP’s can justify in terms of market share (percentage of total addressable market) and pricing (either reimbursed or out-of-pocket). In case of a truly novel product or indication, a primary market research study and/or pricing and reimbursement study should be performed to gain deeper insights in to the fact that the TPP will actually yield the estimated future revenues.  

Besides making an assessment of the potential revenues, making a good assessment of the costs associated with being able to generate the revenues, such as the Cost of Goods Sold (e.g. manufacturing and distribution) and Sales and Marketing, are also important to take into account as these can have a meaningful impact on the FCF.

The COGS of biologics for example typically are around 10-15% of generated sales. Being able to optimize the COGS with a % point can provide direct additional FCF via self-commercialization of the product or via better royalties when out-licensing. Besides the pricing and important element is to make sure that the (timelines of) scale up of production and delivery are estimated correctly.

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[1] Only in case of an out-licensingtransaction a positive FCF can be recognized in the hands of the originator. However, from a drug only perspective this is not recognized as it regards anoutside investment in future cash flows of the asset, not revenuegenerated by the asset.

Third Vector: Risk

The third and last vector that needs to be analyzed when performing a rNPV analysis of a biotech or pharma product is the element of risk associated with (the development of) this product. To account for the associated risks 2 elements are reviewed: the WACC and the clinical development risk.

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The Weighted Average Cost of Capital (WACC)

The WACC isa commonly used financial metric for general net present valuations. It basically reflects the discount rate applied to the future cash flows to reflect their current value today. The WACC calculates a company's overall cost of capital and reflects the value of a project by adjusting its future cash flows for risks associated with a company's financing and investment decisions. These risks include:

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Market Risk: the risk associated with changes in the overall market conditions, such as interest rate changes, inflation, and fluctuations in the stock market.

Credit Risk: the risk associated with a company's ability to pay back its debt obligations. A higher credit risk will result in a higher cost of debt financing.

Business Risk: the risk associated with a company's operations and ability to generate cashflows. A higher business risk will result in a higher cost of equity financing.

Financial Risk: this refers to the risk associated with a company's financial structure, such as its level of debt and interest rate sensitivity.

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By accounting for these different types of risk, the WACC provides a comprehensive measure of a company's overall cost of capital, which is used to evaluate the potential risks and returns of a project. The WACC can be calculated on a company only level using a specific formula, or it can be derived from a comparative analysis of WACC’s of similar companies. It goes beyond the scope of this article to go into detail of all intricacies of these methods.

Clinical Development Risk

What sets the valuation of a drug in development apart from other assets or companies, is that it is pre-revenue for a long period of time and it has a very specific risk profile. The process of passing all stage gates of a regulatory approval process set by the governing authorities (EMA, FDA, etc.) entails a high level of complexity and risk. To account for the clinical development risk, an assessment is made of the probability of success (PoS) of getting a certain product through the different development phases and approved.

The probability of success is an estimate of the likelihood that a product will be approved by regulatory agencies and is dependent on a wide variety of factors such as the stage of development of the product, the therapeutic area, the modality, availability of biomarkers and so on. The TPP forms also in this case the starting point of the assessment.

By adjusting the estimated future cash flows for the probability of success, the rNPV calculation reflects the development risk associated with the project in its current value.

Analyzing and optimizing for both risk factors has a very beneficial impact on the rNPV of a product. Furthermore, performing a thorough analysis of the risks can provide insights into potential risk mitigation strategies.

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Limitations

Performing a rNPV analysis on a biotech or pharma product is a very useful tool for evaluating the potential risks and returns of an R&D project. However, there are several limitations to this type of analysis that need to be kept in mind:

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1. The quality of input data is a critical factor in the accuracy and usefulness of a rNPV analysis. If the input data is inaccurate or incomplete, the resulting analysis may be misleading and can lead to poor investment decisions. However, given the nature of biotech or pharma product development and the changing market and regulatory landscape over time there will always be an element of uncertainty relating to the input data. Running a sensitivity analysis can provide insights into the variability.

2. An rNPV analysis is a way to calculate the intrinsic value of a product based on its underlying fundamentals. However, this does not take into account current market factors that can have an impact on the current market value such as economic conditions, (company or industry) news, and investor sentiment. Performing a valuation benchmark on recent transactions can provide further calibration of the current market value of a product.

3. If the drug gets approved and is sold, the PoS risk reflected in the rNPV estimations has disappeared and the actual cash flows should start to arise. For forecasting and cash projection purposes it is therefore useful to also reflect the NPV value of a drug next to the risk adjusted numbers.

4. The outcome of a rNPV analysis depends on the strategical decisions (to be) made regarding the development and commercialization of a product. For example performing a rNPV analysis based on self-commercialization of a product versus out-licensing to a partner provides for a (vastly) different outcome in valuation. Therefore, it is important to understand that different strategical scenarios have an effect on the outcome of the rNPV analysis and that other relevant factors, such as the impact of the required financing that needs to be raised to reach the goals, come into play as well and have an impact on the value share for the company and its key stakeholders.

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Insights

Performing a rNPV analysis on a biotech or pharma product provides for a more comprehensive decision-making framework for optimizing the return of investment of R&D work carried out in the pharma and biotech industry. Some specific insights that can be gained from performing a rNPV analysis include:

Realistic estimation of expected returns: a rNPV analysis takes into account the uncertainties and risks involvedin a project and provides a more realistic estimate of the expected returns.This can help decision-makers make informed decisions on whether to proceedwith the investment.

Identification of key risks: a rNPV analysis can help identify the key risks and uncertainties that need to be addressed before proceeding with the project. This can help companies better prepare for potential risks and uncertainties and mitigate them effectively.

Evaluation of alternative scenarios: rNPV analysis can help decision-makers evaluate alternative scenarios and determine the most appropriate investment decision given the level of risk involved. This can help companies explore different options and identify the most optimal strategical decision.

Stress-testing of assumptions and estimations: running a rNPV analysis requires the team in charge of the project to gather all the required input data on the different elements, ranging from the choice of indication, timelines on enrollments, to market protection strategy and market size, which typically leads to thorough discussions, optimalization and benchmarking of the overall business & strategy plan.

Better decision-making: performing a rNPV analysis provides a more comprehensive understanding of the potential value and risk of an investment, which can lead to better decision-making and improved returns of a drug in the long run.