Valuation of Pharmaceutical and Biotechnology Companies: DCF (Part 1)

As most Finance professionals say valuation is more like an Art rather than Science. There are various valuation methodologies that one could apply in order to determine the value of a company. The main methods are: Discounted Cash Flow (DCF), Comparable Multiples Method (CMM), Comparable Transactions (CT) and Real Options (less common).

DCF incorporates the future cash flows of the company, its discount rate  (WACC – weighted average capital cost) and the time period of the projections. As an example the valuation of Sanofi-Aventis will be peformed as of 31.12.2005.

Step 1: Determination of Free Cash Flow

Free cash flow represents the cash flow available for distribution. The following formula is usually applied for the calculation of free cash flow (to the firm):

FCFF Formula

Free Cash Flow to the Firm – Estimation

Where:

EBIT = Earnings Before Interest and Taxes

  • Defined as: Sales – Cost of Goods Sold (COGS) – Operating Expenses – Depreciation, Amortisation

T = Effective Tax rate

  • Country Specific. A special care should be given on the country’s tax law. For example, in some countries, tax losses can be carried forward and therefore the effective tax rate will differ from the common flat rate.

d(NWC) = Change in Net Working Capital

  • Defined as (Current Assets – Current Liabilities) at current period  less (Current Assets – Current Liabilities) at previous period

CAPEX = Capital Expenditure

  • Defined as (Property, Plant and Equipment + Intangible Assets) at current period  less (Property, Plant and Equipment + Intangible Assets) at previous period.

D&A = Depreciation & Amortization

The next step in order to determine the value of the company is the calculation of WACC.

FCF in complex situations, where balance sheet items cannot be easily determined (e.g. in the case of multinational companies), can be also calculated as:

Free Cash Flow Alternative Calculation

Free Cash Flow to the Firm – Alternative Formula

This formula shall also exclude restructuring costs and non-recurring items.

Step 2: Determination of WACC

WACC takes into account the capital structure of the company (i.e. amount of equity and debt) as well as the risk of equity and risk of debt.

WACC Formula

WACC Formula

Where:

E = Value of Equity

  • E can be determined by taking the 3-month average market capitalisation of the company or market capitalisation as of the reference date

D = Value of Debt

  • D can be found in the financial statements of the company

V = E + D

  • Sum of E and D

Re = Cost of Equity

  • Re can be estimated using the Capital Asset Pricing Model (CAPM)
Capital Asset Pricing Model (CAPM)Z

Capital Asset Pricing Model (CAPM)

    • Where Rf is the risk-free rate which can be estimated from the yield of long-term bonds of the in which the company operates (e.g. U.S. 10-year bond yield ~3%).
    • Where β represents the volatility of the company’s stock price in the capital markets (can be found in financial statements or real-time stock information providers). Often referred as levered beta.
    • Rm – Rf is the equity risk premium (long-term return from the financial markets excess risk-free rate). Damodaran provides updated values of equity risk premiums.

Rd = Cost of Debt

For publicly traded companies WACC depends on the capital structure of the company. Cost of debt is in most cases less than the cost of equity because cost of debt is tax deductible. According to the Modigliani–Miller theorem if a company reaches the point of financial distress, cost of debt has a negative effect in the optimal capital structure of the company. As a result WACC increases and the value of the company is reduced.

Step 3: DCF Calculation

Discounted cash flow method uses projected cash flow to determine the current value of the firm. The formal formula for DCF is:

Enterprise Value Calculation - DCF Formula

Enterprise Value Calculation – DCF Formula

Where:

TV = Terminal Value

i = the specified year

n = the number of years

The second part of the equation is called Terminal Value. This is done to compensate for uncertain future returns (i.e. future cash flows cannot be estimated up to infinity).  There exist various models for terminal value. The most common model is the stable growth model, as shown in the formula above. This model assumes that the company will grow with a specific growth rate defined as g. It has been suggested that this growth should have two main features: a) It should represent the company’s growth at maturity in its life cycle, b) it should be less than the world’s or country’s GDP growth rate (otherwise the company would be “larger” than the world at infinity). Damodaran has provided a more in-depth analysis of the different types of terminal values.

Example: DCF valuation of Sanofi-Aventis as of 31.12.2005

In this example the value of Sanofi-Aventis will be estimated as of 31.12.2005 and will be compared to the market capitalisation of the company at the same period. This is done because it is highly difficult to perform a current DCF, since there are various parameters that cannot be accurately determined (e.g. future sales, future investments, restructurings etc.). However, an interesting conclusion that can be drawn from this analysis is whether the market was overvaluing or undervaluing the shares of the company at that time. In addition, if this methodology is performed in a large sample of pharmaceutical companies a historical overview of how the market valued the stock of pharmaceutical firms in the past can be obtained.

Based on published and audited consolidated financial data of Sanofi during the period 2005 – 2010 (see Sanofi Annual Reports) and author’s analysis the following results were obtained:

Enterprise Value Estimation - Discounted Cash Flow Approach

Enterprise Value Estimation – Discounted Cash Flow Approach

A growth to perpetuity of 3% was assumed. In addition, it has been assumed that CAPEX will be equal to D&A in perpetuity (therefore free cash flow formula used in terminal value will be lower than previous years if in previous years D&A was higher than CAPEX). This is because at perpetuity growth CAPEX shifts to replacement CAPEX, meaning that the Company tries to offset the effect D&A rather than introducing new capital investments. In addition, at Terminal Value FCFF was actually calculated rather than assuming last years FCFF and applying the growth to perpetuity in order to apply the previous adjustment (D&A = CAPEX).

The market value of equity using DCF was estimated at € 91,925 mn. based on the analysis above. The market capitalisation of Sanofi-Aventis as of 31.12.2005 was € 103,656 mn.

 

Conclusion

There exist two potential explanations for the variation between intrinsic (DCF) value and the actual market capitalisation of Sanofi. Firstly, the market does not have the information that already exists (as this is a historical valuation). For example, an acquisition would increase CAPEX (which reduces FCFF in the short term) but in the longer term it would cause EBIT to rise and potentially result in a share price increase. However, the reason the 2005 – 2010 period was selected is that it is after the merger between Sanofi and Aventis in early 2004 and before the Sanofi – Genzyme acquisition, to avoid any distortions caused by the latter transaction. Secondly, historical DCF valuation uses a specific time range (of up to 5 years + terminal value for mature companies, while 8-10 years + terminal value for start-ups) based on actual FCFF values while the share price is based on investors’ expectations which are occasionallyshort-term. Moreover, small changes in WACC and growth to perpetuity can have a major effect on the overall market value of equity estimation. Finally, considering the sensitivity of the model on such effects, it can be said that overall, the intrinsic value of Sanofi agrees with that of the market. This means that investor’s expectations were realistic at that time as they were aligned with the actual performance of Sanofi-Aventis.

Within the next week the Valuation of Pharmaceutical and Biotechnology Companies: Comparable Multiples Method (Part 2) will be published which will be compared with the results of the DCF approach.

Can biotech Mergers and Acquisitions save big pharma?

A question that seeks answer in view of the challenges that the pharma industry is currently facing globally and specially in Europe.

Pharma has to find ways in order to improve Research and Development (R&D) productivity by reducing development time frames, R&D costs and increasing the chances of success from pre-clinical phases to market launch. As these interdependent factors have remained stable or even worsen (cycle times and probability of success at each phase have not changed significantly while R&D costs have impressively increased since 1990s) pharma has to seek other methods in order to overcome these huge challenges.

In my view there are several ways to tackle these challenges:
i) Entrance to new therapeutic areas with unmet medical needs and large market potential can, in the long-term be a source of ensuring cash inflows. Adapting such entrance directly at emerging markets (BRIC) can prove successful.
ii) Filling the pipeline gap.
iii) The convergence of diagnostics with pharmaceuticals for efficient and effective drug delivery that can prove to be an additional revenue source which can then be re-invested for R&D purposes.
iv) Developing orphan drugs, not so much for financial reasons but for restoring industry’s damaged reputation.
v) Personalised medicine; need to say more?
From a company’s strategic perspective there are two main pathways for achieving these solutions: M&A and organic growth. M&A has been well-incorporated as a significant part of pharma companies’ strategy, mainly big pharma. But what are the major features of these deals in the different M&A waves? During the 1980s and 1990s there was a significant amount of pharma-pharma “mergers of equals” (at a national level) aiming at gaining knowledge about monoclonal antibodies and genetic engineering for drug discovery. In the post-merger period absorption was the most common integration technique. From the late 1990s onwards, particularly after the genomics boom, the investment community realised that there are many years ahead for the sequencing of the human genome to actually add value both financially and medically. From that point onwards, for pharma, issues such as clash of cultures, post-merger integration techniques and potential disruption of R&D, were secondary. The pharma industry performed many mega-acquisitions and hundreds of small acquisitions which had one key characteristic in common; most of the companies acquired were biotech companies present in different geographical areas (cross-border M&A). A preservational approach was used as a post-merger technique to avoid cultural clashes and financial risks as well as the time consuming and extensive process of due dilligence (which can strongly disrupt every-day decision making). The key drivers for this shift from national mergers in order to dominate, to acquisitions in order to fill the pipeline gap are mainly the intense competition from generics (70% of prescriptions in the U.S., see source 1), patent expirations (between 2010-2014 the revenue of the prescription sector is expected to be reduced will by approximately US$ 110 bn, source 2) and the pressure for lower healthcare costs (as buyers demand lower prices and reference pricing is a growing pricing strategy for public healthcare systems).
However, why did pharma choose biotech? As an industry expert had once told me “pharma missed the boat” and so it wants to catch up. But regardless of this historical explanation the main reason that big pharma focused on M&A of early and mid- stage biotech firms is biotech’s strong R&D platforms and high prospects (although having equity as the only source of funding and make little or no revenues). Pharma companies also have strong R&D focus but marketing and sales force effectiveness remain the number 1 in terms of resource and cost allocation. It has also been concluded that biologics have an overall higher chance of approval compared to chemical compounds. In addition, generics are an exact copy of branded drugs, while for biologics there are biosimilars. There is a much greater difficulty for developing biosimilars and hence, this can provide pharma companies by acquiring biotech firms, a “virtual” extention of market exclusivity.
Coming back to M&A trends; M&A intensity has remained fairly stable particularly after the beginning of financial crisis in 2008. M&A model of growth is shifting towards a hybrid model in which pharma companies form strategic alliances/partnerships or perform licensing deals with biotech firms paying them in tranches rather than up-front. In such performance-based approach pharma decides whether to acquire the biotech firm in the future or not based on its success or failure during the partnership.
The last model of growth is organic growth. This is the model followed by biotech companies up to the point which they are acquired from pharma (e.g. Sanofi-Genzyme, Roche-Genentech, AstraZeneca-MedImmune etc.). Companies that have grown organically are characterised by a high degree of autonomy and independence. But even Merck, the brightest example of such growth model, performed its first mega-acquisition by acquiring Schering-Plough in 2009. Organic growth for big pharma is not a solution anymore in such a mature and saturated market. For biotech firms, it can both be an exit strategy and a viable growth model to ensure their survival.
So can biotech M&A save pharma? In such an uncertain and ever-changing environment, the answer is: it depends. It depends on the type of M&A (horisontal or vertical, friendly or hostile), on the expectations and reactions of the investors and finaly it depends on post-merger financial strategies (do you follow the same straight-forward cost-saving strategy in R&D as in sales and marketing?). In my view, a hybrid model is required: performance based preservational M&A in combination with open innovation (in-licensing, out-licensing) and strategic alliance/partnership formation. Most big pharma companies have already started choosing this model realising its declining R&D productivity but its strong marketing and sales effectiveness; Incorporating biotech’s R&D focus and rational compound targeting and pharma’s marketing success can eventually prove to be a viable and successful business model.