DCF and NPV Methods and the effect of initial sales and sales growth

Before moving forward with subject of this article you may download the excel model from the link below:
Valuing start-up and early stage biotechnology companies is particularly difficult. In particular, early stage biotech and pharma companies have high sunk costs (i.e. fixed costs that cannot be recovered) and at the same time few or no sources of revenue at all. As a result most or all their Profit & Loss (P&L) items such as EBIT and Net Income have a negative sign. This restricts the ability to value these types of companies through a Comparable Multiples Method (CMM) or Comparable Transactions Method (CTM). Therefore, DCF and Venture Capital Method (see: A Simple VC Investment Model: What every Biotech Entrepreneur should know) of major importance. This article will focus on how DCF and NPV can be applied to value an early-stage biotech company.
In order to value a company using the Discounted Cash Flow (DCF) method the following variables shall be taken into account:
  • R&D Cost by Phase: This can be provided by the Management of the company (as estimates). For the purpose of this analysis the figures provided by Bogdan and Villiger.
  • Attrition Rates: Probability of approval by phase – Assumed based on past studies/cases
  • Discount Rate: Discount rate of the project can be assumed to be the same as the discount rate of the company, if the company has one project or very few similar ones (i.e. same therapeutic area – same risk etc.) Discount rate (and more specifically, beta) decreases each time a drug passes to the next phase of clinical trials because the project becomes less riskier as the product gets closer to the market. The discount rate is estimated through the Capital Asset Pricing Model (CAPM).
  • Post-approval revenues and costs: In order to value the company sales forecasts are needed. That is particularly hard and risky to do because of the uncertainty of the market, the economy, the regulation or even tax policies in general in 6-7 years from now. However, revenues and costs are necessary to estimate future free cash flows of the firm or the project.
  • P&L and Balance Sheet items: Items such as Cost of Goods Sold (COGS), Selling, General and Administrative (SGA) costs, EBIT margin, CAPEX and Working Capital will be assumed as a % of sales based on comparable companies (high growth, medium growth and maturity companies).
  • Free Cash Flow calculation (1/2): If revenue projections have already been obtained (from the company’s management) the next step is to estimate operating expenses that lead to EBIT. By assuming an appropriate tax rate, estimating CAPEX (capital expenditure on fixed assets), change in Working Capital and Depreciation & Amortization (using the relevant method, e.g. straight line) Free Cash Flow to the Firm (FCFF) can be calculated by using the following formula: FCFF = EBIT*(1-T) + (Depr’n & Amortisation) – CAPEX – Change in Working Capital
  • Free Cash Flow calculation (2/2): If revenue projections have not been provided by the management of the company then there are two alternatives. The first one is the market method and the second is the comparable method. The former suggests that the market forecasts and statistics should be found  (e.g. if the product is a cancer drug then forecasts for the oncology market need to be found – it would be even more relevant if forecasts of the subsector can be reproduced i.e. if the product is monoclonal antibody cancer drug, then research the monoclonal antibody cancer market). Then estimate the therapeutic area’s statistics (potential number of patients targeted for the treatment based on disease prevalence) estimate pricing (search for comparable products to see prices and look for social insurance reimbursement percentages) and of course examine market access and penetration issues that may arise and perform quantitative (by looking at past products) and qualitative analysis (ask doctors whether they would prescribe that drug or not, do questionnaires, focus groups etc.) based on this information.
Using the assumptions outlined and those discussed above, the following steps were taken to come out with the results:
STEP 1: Comparable Companies (COGS, SG&A, EBIT Margin, WACC)
Comparable Companies

Figure 1: Comparable Companies

STEP 2: R&D Costs by Phase
R&D Costs by Phase

Figure 2: R&D Costs by Phase

STEP 3: Discount Rate by Phase
Discount Rate by Phase

Figure 3: Discount Rate by Phase

STEP 4: Discounted Cash Flow Results
Initial Sales that result in an NPV = 0 have been used (i.e. USD 132 mn.). Sensitivity analysis has been applied to observe how initial sales shape NPV of the project (see Step 5).
Discounted Cash Flow Methodology

Figure 4: Discounted Cash Flow Methodology

STEP 5: NPV of the Project
NPV of the Project

Figure 5: NPV of the Project

STEP 6: Sensitivity Analysis – Effect of Initial Sales and CAGR on DCF and NPV
Sensitivity Analysis - Initial Sales and CAGR effect on NPV

Figure 6: Sensitivity Analysis – Initial Sales and CAGR effect on DCF and NPV

Figure 6 depicts the exponential effect of sales CAGR on DCF Valuation for different initial sales values while initial sales follow a linear relationship with DCF valuation for different CAGR. For a minimum initial sales of USD 25 mn. the product needs a CAGR of 35% for a positive NPV, while for the minimum CAGR of 15% initial sales should be at least USD 200 mn. in order for NPV to be positive.
There are various financial modelling difficulties (subjectivity, unreliable forecasts, risk) in DCF but these can be reduced if the company to be valued has already secured a licensing agreement of its product(s) with a big pharma company. Then a Comparable Licensing Deals Valuation can be applied, in which the appraisal is based on licensing and royalties revenue development and how costs are distributed between the licensor and the licensee, what is the risk and value shared etc.
For VC-backed early-stage biotech/pharma companies there is also the Venture Capital Method which can be more accurate as it is based on investors’ requirements (return, exit strategy etc.). If the investment fails the company is in trouble while the investors moves on to another company and expect that their return on investments to the next company will cover the cost of the failure (+ profit) from the previous investment.
Of course there can be a combination of the methods outlined above, i.e. a VC firm will probably invest in a company that has already proven its ability to potentially develop successful products, i.e. a company that has already out-licensed one of its products. Such company will probably have less strict terms by the VCs as opposed to a company that has not secured any deal. In that case, model-wise, a valuation model should be considered that will incorporate VC investments as well as licensing deals.

Viropharma Acquisition by Shire Pharmaceuticals: Was the price right?

Shire Pharmaceuticals acquired Viropharma for USD 4.2 bn. Was the price right? What does Comparable Multiples Method say?

In order to determine whether the price was right, a sample of comparable (publicly listed) companies was collected together with their multiples (Figure 1). Values marked with red colour represent outliers.

Viropharma Multiples

Figure 1: Viropharma Comparable Companies Multiples (Source: FY 2012 Financial Statements)

In Figure 2, the market value of equity of Viropharma was estimated based on the multiples presented above.

Figure 2: Implied Market Value of Equity of Viropharma

Figure 2: Implied Market Value of Equity of Viropharma

It should be noted that equal weights were given to all multiples which resulted in a weighted average market value of equity of USD 1,658 mn. From January 2012 to September 2013 (i.e. until Shire Pharmaceuticals showed interest which could have effect on share price), market capitalisation of Viropharma was ranging between USD 1,342 to USD 2,309 mn. with average market capitalisation (over the same period) being ~ USD 1,785 mn., converging highly to the market value derived through the Comparable Multiples Method (difference of the order of 7%). Therefore, it can be implied that the market valued Viropharma “realistically”.

On November 7th 2013 the market capitalisation of Viropharma reached ~USD 3,300 mn. The acquisition price is usually implied as follows:

Acquisition Price = Market Value of Equity + Control Premium + Synergies Premium

Control Premium is approximately 20% of the market value of equity. Since market value of equity and acquisition price are known, synergies premium should be of the order of USD 300 mn. This amount may also incorporate the Net Present Value of Viropharma’s pipeline (1 pre-clinical, 2 phase I and 5 phase II products). Indeed, according to the Financial Times through this acquisition, Shire Pharmaceuticals may achieve synergies of USD 150 mn. by 2015.

From a valuation perspective, it can be concluded that Shire Pharmaceutical’s offer converged to market reality, mainly arising from the reasonable total premium offered.

Strategic Target Screening in M&A: When and How?

Acquisitions has been one of the major strategies for growth in several industries including pharmaceuticals and biotechnology. It is well-known that 3/4 of all acquisitions end up as failures. This article focuses on how to identify the right acquisition targets based on the company’s needs and future prospects. Before deciding to pursue an acquisition the potential acquirer needs to identify its weaknesses, whether these are linked to the motives of the acquisition and if so, how. Instead, if the company is trying to anticipate market or competitors’ moves target screening and selection should also be modified. Some conceptual and practical steps are discussed below:

Identify your Company’s Weaknesses

Before deciding to make an acquisition and justify the motive behind it, it necessary to perform an analysis to identify the weak spots of your company and which of the weakness you expect to improve through the acquisition. In general a company’s weakness can fall into the following categories:

  • Operational: Research, Development and Manufacturing
  • Financial: Low appreciation of capital markets towards your company (Stock price, expectations)
  • Market Access: Brand awareness as a marketing barrier to entry

Identify Motives & Criteria

A particularly important factor to consider is the acquirer’s motives and how these relate to improving the company’s weaknesses over the long- short or medium-term (assuming that is the aim for the acquisition/merger). These are the principal factors shaping the criteria for target screening. This relationship is illustrated in the table below:

Motives & Criteria

Motives & Criteria

Time factor refers to whether the motive for acquiring a company can cope with the acquirer’s weakness in the short-term, medium-term or long-term. There are also additional criteria that can make target screening proactive. This means that, If the acquirer is considering to acquire an early-or mid-stage firm it is important to search activity of the target firm in scientific conferences, intensity of scientific publications and in the scientific community in general.

Target Screening

Using the relevant criteria and motives it is possible to start screening attractive targets. In order to do that it is vital to gain access to a database or platform that incorporates the company descriptions, number of employees as well as companies’ financials.

  • OneSource: A multi-industry database that allows the subscriber to screen by SIC Code (or other codes), country or revenues. The main advantage of OneSource is that it includes millions of private companies across the world with accurate descriptions (http://www.onesource.com/corporate/)
  • Evaluatepharma: A pharmaceutical industry database. It incorporates historical data as well as forecasts, information about investors in the industry and data for sub-sectors (http://www.evaluategroup.com/Default.aspx)
  • Mergestat: A databases dedicated for providing with historical M&A data. With Mergestat one can search control premiums, past deal values and acquirers’/targets’ financials at the time of acquisition or merger. Useful for performing a comparable transactions valuation for potential targets (http://www.factset.com/data/factset_data/factsetmergers)

Next Steps

Once the target sample has been developed, the acquirer needs to conduct further research on the targets. That may include one or more of the following:

  • Indicative valuation of the targets’ intellectual property (e.g. patents) based on past transactions or historical growth of comparable companies, especially when it comes to early-stage firms
  • Contacting the targets’ executives
  • Contacting third parties (investment bankers, financial advisers)
  • Discuss about potential due diligence
  • Deciding on which targets would be easier to integrate, based on size, culture and expertise and how (absorption or preservation?) 


 Target screening is crucial as it determines on which target(s) the due diligence will be performed. This article integrates the motives and criteria for target screening, examples of appropriate online platforms as well as additional steps. Failing at developing a good target sample could lead to increased risk of an unsuccessful acquisition.

5 Ways to Boost your Company’s Stock Price

Stock Prices is the result of demand and supply forces in the capital markets. It is not necessarily linked with financial performance of the company, especially in the biotechnology sector. In fact, a significant amount of the biotech companies being acquired or after raising equity through an IPO (two of the main exit strategies) have negative Net Income. The reason is the huge amounts of capital required to push a product into the market as well as market access and reimbursement issues after the product has been approved. The capital markets and the investors are well aware of these issues and therefore they focus on companies that could bring great returns in the medium to long-term either in the form of dividends (which implies that the company needs to have positive net income) or stock price increase.

This article focuses on how a pharmaceutical company can boost its stock price. It should be noted that the suggested means are not definite and there are certain risks and pitfalls when using these methods. Hence, the disadvantages of these methods are also discussed.

Stock Repurchase (or Stock Buy-Back)

Stock repurchase has been a common method to boost share price. The reason is that in a stock buy-back the demand for the stock increases and hence its price. It is a way to convince the markets that the stock is reliable and that the company believes that its future performance will improve. A selected number of major stock repurchases of large pharma and biotech companies is shown below:

Pfizer: $10 billion Stock Repurchase Program (Announced in 2013)

Johnson & Johnson: $12.9 billion Accelerated Share Repurchase (Announced in 2012)

Amgen: $10 billion Share Repurchase Program (Announced in 2012)

Biogen: $3 billion Share Repurchase Program (Announced in 2007)

So how has these companies performed since the stock repurchase programs were announced? The following graphs show the stock price variation since the stock repurchase programs were announced.

Pfizer Stock Price since Stock Repurchase Program Announcement

Figure 1: Pfizer Stock Price since Stock Repurchase Program Announcement

Johnson & Johnson Stock Price since Stock Repurchase Program Announcement

Figure 2: Johnson & Johnson Stock Price since Stock Repurchase Program Announcement

Amgen Stock Price since Stock Repurchase Program Announcement

Figure 3: Amgen Stock Price since Stock Repurchase Program Announcement

Biogen Stock Price since Stock Repurchase Program Announcement

Figure 4: Biogen Stock Price since Stock Repurchase Program Announcement

It can be seen that in all cases there was a minor to major increase in stock price of these companies. However, there are large discrepancies; Pfizer shows a $1 increase in stock price while Biogen has experienced a 4-fold increase in its stock price. This indicates that there are numerous factors affecting the stock price such as M&A, regulatory & legal issues, company expectations and investor expectations. Therefore, one cannot simply draw conclusions from stock fluctuations but it can be, in some cases indicative of the impact of stock repurchase programs. A comprehensive and interesting analysis on this subject has been provided by Life Sci VC.

Raising Debt

Financial Theory supports that capital structure does not have an effect on firm value; However, in the real world capital markets are largely based on psychology and every move can have an impact. Raising debt can lower the overall risk of the firm provided that the firm has not reached the point of financial distress yet (i.e. the firm is unreliable and unable to pay short-term debts). In addition, depending on the amount of debt raised and how it will be used it may have a positive effect on the stock price. An example is that of Pfizer that raised $13.5 bn. in debt (in the form of corporate bonds) in March 2009 and since then its stock price has been higher than the debt offering announcement.

The types of debt raised may also affect -indirectly- the stock price of the firm based on debtor’s timely returns and flexibility.  The different types of debt are described below (As described by Bender and Ward, “Corporate Financial Strategy”, 2008):

  • Secured Debt: Backed by a collateral, low interest rate and low risk (e.g. corporate bonds).
  • Unsecured Debt: Partial covenants, medium interest rate and risk (e.g. debenture).
  • Mezzanine Debt: Covenants may exist, high interest rate and risk, convertible to equity.
  • Subordinated Debt: No collateral, very high interest rate and risk.

Selling preferred shares can also be considered as a way to finance a company. Although it is an equity measure, it features some characteristics of debt securities and is more directed to the financial performance of the company. Main characteristics of preferred shares (Miller, “Valuing a Preferred Stock”, 2007):

How Preferred Shares Characteristics May Affect Value

Figure 5:How Characteristics of Preferred Shares May Affect Value

Convertible, cumulative preferred shares with fixed and adjustable dividend rates and voting rights are more likely to attract investors and increase the demand of the preferred stock which may allow the company to further improve the terms of the preferred stock thus leading to an improved enterprise value. This in the long-term may prove beneficial to the common stock as well.

Organisational Restructuring

Organisation Restructuring requires evaluating, valuing and prioritising the main assets of the company. For example, if your company has multiple business divisions and business units can have “subunits”. As an example, considering a fully integrated pharmaceutical company which its operations lie on two main therapeutic : oncology and cardiovascular in which they are both split in mature products and early-stage products. Valuing the projects or the business units based on financial performance (e.g. sales growth, EBIT margins) is crucial for the firm (see figure below).

Organisational Restructuring

Figure 6: Organisational Restructuring

If a business unit or a subunit performs well below than the overall performance of the firm then the firm may consider to either raise funds for that unit to organically grow or sell that business to another firm. This will show investors a willingness to grow, improve financial performance that could potentially (in the long-term) be rewarder through a higher demand for equity.

Mergers & Acquisitions (M&A)

Consolidation is a major trend in the pharmaceutical industry due to the high M&A activity in the sector. There is an extensive literature in the field of M&A and particularly its effect on shareholder value and stock price. The table below shows a number of studies that have examined this effect:

Literature - Effect of M&A on Stock Return

Figure 7: Literature – Effect of M&A on Stock Return

It can be seen that the majority of these studies conclude that the effect of M&A on stock return is positive.

It should be noted though that due to the fact that most of these studies have used econometric analyses (regression) as their methodology, a large time-series data is required for the effect of time-lags to be smaller in order for the model to show significant results. In other words, small time-lags are used thus implying that these positive effects are short-term while long-term effects of M&A on stock price is not completely visible.

Diversifying Portfolio

If a company is profitable, a certain % or absolute amount of net income is usually reinvested to the company. The rest can be distributed to shareholders as dividends which can have a positive effect on stock price depending on the consistency and the (relative, i.e. compared to previous year) amount of dividends distributed.

An additional strategy can be using a small percentage of net income as capital investments to other companies. The figure below shows the types of investments (public equity, public debt and private) that can be made assessed by their level of risk and return (click on the figure to see graphs more clearly):

Level of Risk and Return of Different Types of Investments

Figure 8: Level of Risk and Return of Different Types of Investments

A portfolio of investments can be optimised by using as a benchmark: (i) average market return, or (ii) 6 month or 1-year average stock return of your company, (iii) Weighted Average Capital Cost (WACC) of your company, or (iv) Industry-specific index average return (e.g. NASDAQ Biotechnology Index – BTK) depending on the (expected) return that a company needs. In order to do that, a historical benchmarking of each type of investment should be performed. The next step is to model different combinations of investments (portfolios) to achieve the required return. Although different combinations may lead to the same required return, adjustments should be made based on the needs and preferences of the company. A sensitivity analysis is crucial as well, as some of the modelled portfolios might be highly sensitive to very few investments which makes the perceived risk high.

Overall, diversifying portfolio is a strategy that may be appreciated by capital markets, as the company will show its intention to diversify its risks and returns from different operations.


In this article 5 ways to boost your company’s stock price have been suggested: (i) Stock Repurchase, (ii) Raising Debt, (iii) Organisational Restructuring, (iv) Mergers and Acquisitions (M&A) and (v) Diversifying Portfolio. The pros and cons of each strategy have also been discussed. A combination of these strategies is more likely to have an impact on the stock price of your company. For example, a company can go through an organisational restructuring through which a certain amount of capital can be saved. Thereafter, the company can raise debt and use the “saved capital” and some of the debt to perform M&A, repurchase stock and diversify its portfolio, or a combination of the three.

Pharmaceutical Industry Profile Report

You can download the Pharmaceutical Industry Profile report free of charge from the link below:

Pharmaceutical Industry Report

The report contains the following four chapters:

Chapter 1: Global Pharmaceutical Market

Chapter 2: Solutions to Challenges

Chapter 3: Global Players

Chapter 4: Overview of Industry Trends

For any questions or recommendations do not hesitate to contact me.


A Simple VC Investment Model: What every Biotech Entrepreneur should know

Before reading this article, you can download the Excel version of the model from the link below:

VC Financing Model – Revised

All Entrepreneurs know that Venture Capitalists (VCs) want is two main things: (i) Return and (ii) Control. They want return because they have invested in a company that operates in one of the riskiest industries of the world and they want control to participate in the decision-making that may affect the future returns on their investments. What are the elements affecting their return on investment? How do these reflect to the valuation of the company after a series of investments?

Before contacting a VC (and you need to have a strategy even for that) you must make sure that you know what you need from them and if it is just capital, how much (a reasonable range) would you need and how would you allocate it (R&D and Marketing, or only R&D and then secure a marketing and distribution agreement with a large pharmaceutical company?). In brief, VCs want:

  • Initial Ownership: Percentage of stock owned by VCs based on their initial investment.
  • Dividend Provision: Future dividends model (no dividends, flat or cumulative?)
  • Exit Strategy: M&A or IPO
  • Liquidation Preferences: Return multiple (i.e. times their initial investment)
  • Type of Stock received: Usually investors required a convertible preferred stock. That is because, initially, they receive all their stock as preferred stock which means that in the case of bankruptcy the investors get paid first and then the rest of shareholders. This is a “shield” to make sure that in case their investment fails they will get back some money back. Therefore, convertible preferred stock reduces the overall risk of the investment. In case where their investment is successful, they have the right to convert all the preferred stock into common stock which can be sold to collect their investment returns.
  • Participation: If the company is sold (or if the equity raised through an IPO) more than its post-money valuation (i.e. premium) then the VCs can “participate” in that premium too.
  • Protective Covenants: usually a  non-competition covenant is applied – an employee is not allowed to work for a competitor for a specified period of time.
  • Board of Directors (BoD) Control: In order for VCs to have actual control on importance decisions made in the company they will certainly ask for board sits.
  • Rights of First Refusal: Rights of first refusal allows the VCs to prevent dilution of ownership in case of additional series of investments from other VCs. Full rights of first refusal means that VCs will maintain exactly the same ownership until exit.
  • Stock Repurchase Agreement: Restriction on stock repurchases from existing shareholders (mainly founders) to avoid concentration of shares in a single or very few shareholders.


Biostrategy Analytics Corp. is a biotechnology company that with its own funds and Angel investors has succeeded in bringing a drug from research to phase I and seeks VC funding for testing the drug in clinical trials. On average an early-stage biotech company needs needs € 60 mn. in total (nominal value) throughout the clinical development period (6 – 9 years). Due to the huge amount of investment required, the company plans to receive three series of investments: Series A, Series B and Series C.

Table 1 presents the Series A model of investment:

Series A Financing

Table 1: Series A Financing

Highlighted in blue are the assumptions of the model, while in green are calculated values. Assuming the initial investment is € 10 mn. and the required ownership is 20%, this gives a post-money valuation of € 50 mn. and a pre-money valuation of € 40 mn. If there are 10 mn. outstanding shares then 2.5 mn. of convertible preferred stock resulting in 12.5 mn. of total shares. The price per share, assuming that all preferred stocks are converted to common stocks is:

Price (€) per Share: pre-money valuation / outstanding shares = € 40 mn. / 10 mn. = € 4

Since this is an investment in an early stage company the risk is very high and the VCs will ask for increased liquidation preferences (4x initial investment) and a participation of 40%. Therefore the required investment return (nominal, i.e. at exit) is:

Required Investment Return at Exit = (Liquidation Preferences)*(Initial Investment) + 40%*(Value at Exit – Post-money Valuation)

In Table 1, the required Investment Return is 4 € 10 mn. = € 40 mn. (participation not taken into account since there is no exit yet at series A).

An additional assumption is that the conversion ratio (if the preferred stock is converted into common stock) will be 1 in all series of investments.

Table 2 below presents the valuation of the company assuming there are three series of investments: A, B and C. As it can be seen the valuation of the company changes depending on the ownership the investors require and the amount of investment dedicated by each VC. Outstanding shares are cumulative (initial shares + shares issued in each Series of investments).

Table2: Series A - C

Table 2: Series A – C

Cells highlighted in red point to the factors that mostly affect the investment return to the VCs and what is left for the founders of the company. The post-money valuation of the company after series C has been estimated to be € 87.5 mn. It should be noted that full rights of first refusal have not been applied in this model.

In table 3, the ownership structure of the company (post-series C) is shown:

Ownership Structure

Table 3: Ownership Structure

The majority of the company’s equity (69%) has passed into the hands of the VCs while only 31% has remained to the founders. In case where full rights of first refusal were applied the company would dilute further. In addition, summing up the investors’ required return gives € 170 mn. (€ 70 mn. + € 60 mn. + € 40 mn.) which is approximately 2 times the post-money valuation of the company. Therefore, only in case where the company raises equity (through an IPO or sold to another company) at least double of its post-money valuation the VCs will get the required return. Entrepreneurs will receive return only if the company raises equity or sold more than double its post-money valuation, and they will only have a 10% participation of that (see Table 4, click on the figure to see numbers more clearly). That is the only pure profit for the Entrepreneur.

Exit Scenario

Table 4: Exit Scenario

In the IPO scenario it is assumed that the company raises € 200 mn. Together with participation, investors receive € 197 mn. and € 3 mn. are left for the entrepreneur. If the company raises € 3 mn. less, then the entrepreneur gets nothing.

In the M&A Scenario, it is assumed that the company is sold twice its post-money valuation. In that case the return for the entrepreneur is much lower, i.e. € 0.5 mn.

Assumptions and Limiting Factors of the Model

1) Time value of money has not been taken into account. This is mainly a static model rather than a dynamic one as it does not take into account the risk profile of the Company, how it changes and how it develops through times. It is rather a model examining the relationship between the value of the company and the investments to it at discrete time points (pre-money and post-money).

2) Full rights of first refusal were assumed non-existent.

3) All VC investments are assumed to be allocated for R&D, Personnel Costs and Other company operating or capital expenditures. Any potential net income is to be reinvested in the company.

In conclusion, every entrepreneur should know that when seeking investments, going the VC way it is like a long journey with many obstacles and when the destination is reached you might not be rewarded.

Valuation of Pharmaceutical and Biotechnology Companies: Comparable Transactions Method (Part 3)

In this article the Comparable Transactions Method (CTM) is discussed. In CTM the valuation of the company is based on the answering the following question: If the company was sold are there any similar transactions have taken place under similar conditions? Could these transactions be used in a comparative manner in the valuation of the company? The following steps can be followed to accurately value the target company using CTM:

Step 1: Analysis of the Target Company

As in CMM (see here) the data needed to be collected for the target company are:

  • Location: headquarters, countries of operation, location of subsidiaries.
  • Quoted Status: Publicly Listed or Private.
  • Product Pipeline: Number of products, breakdown of products’ type.
  • Revenue structure: breakdown of revenues by area.

Step 2: Characteristics of Comparable Transactions

The CT sample should fulfill the following criteria:

  • The target company shall have a similar business description if available.
  • When researching for acquisitions (comparable transactions) the SIC code should be the same or close to our company.
  • Comparable transactions should have been completed at most 3-4 years prior to the valuation date.

Step 3: Collection of Comparable Transactions Data

Two types of data need to be collected for CT valuation. These are:

  • Transaction Financials: Price to Sales, Enterprise Value to Sales, Price to Earnings After Tax (EAT), Enterprise Value to EBIT.
  • Financials of the Company to be Valued: Sales, EAT, EBIT, Net Debt (Debt – Cash).
  • Other: Target Ownership (Public or Private), Announcement Date of Transaction, Percentage bought by bidder in each comparable transaction.

Step 4: Analysis

Before estimating the average and the median of the transaction multiples a two-fold adjustment has to be made in the equity value of the target company in each comparable transaction:

  • Discount for Lack of Marketability: If the target company in the CT sample is a private company and the company to be valued is public (or vice versa) then the equity value of the target company has to be adjusted. This occurs because a private company does not have a comparable equity value with that of a public company and that is because a public company has better liquidity and better access to the capital markets.
  • Control Premium: For each transaction in the CT sample it must be known whether the bidder has acquired a majority or a minority of the target’s equity. If it is a majority stake then the bidder paid a control premium which should be subtracted to find a realistic transaction multiple.

Since, it is almost impossible to find the discount due to lack of marketability and the control premium for each transaction an industry average can be applied (based on the industry classification code named SIC Code).

Control premiums for past transactions can be found here. For example, the SIC Code for the pharmaceutical industry is 2834. In the link attached, 14 transactions took place in the pharmaceutical industry in the first quarter of 2012. Taking the average of the control premiums of the above sample (excluding outliers) a representative control premium can be found if you are valuing a pharmaceutical company in 2013 or 2012. Typical control premiums can range between 15% – 45%.

Marketability discount can be found by looking at recent Initial Public Offerings (IPO) of companies in the relevant industry and comparing the company’s equity value pre-IPO with the market value of equity in the post-IPO period. Marketability discount varies by industry and company size but it is typically between 20% – 40%.


Adjusted Equity Value When Valuing a Public Company = Equity Value * (1 + a*CP + b*MD) (i)

Adjusted Equity Value When Valuing a Private Company = Equity Value * (1 + a*CP – b*MD) (ii)

  • a = 0 if the bidder buys a minority stake
  • a = 1 if the bidder buys a majority stake
  • b = 0 if the target company is public
  • b = 1 if the target company is private

If net debt is also known for each target company in the CT sample the Adjusted Enterprise Value can be estimated by adding the Adjusted Equity Value with net debt. If net debt cannot be obtained then reported (e.g. annual report) EV measures can be used.

As a final step, the transaction multiples are calculated by dividing  Adjusted Enterprise Value and adjusted equity value with the target company’s sales and EBIT and EAT. By finding the average of these ratios (excluding outliers) and multiplying by the company’s parameters the final value of the company can be obtained.

Example: CT Valuation of Sanofi (As of 31.12.2005)

Sanofi is publicly listed therefore equation (i) applies in regards to adjusted equity value.

The following CT sample 13 comparable transactions were identified (click on the picture to see numbers more clearly). A control premium of 25% and a 25% marketability discount have been applied.

Comparable Transactions Sample

Comparable Transactions Sample

The CT sample above produced the following multiples:

Comparable Transactions Multiples

Comparable Transactions Multiples

Using the CT multiples above and the Sanofi-Aventis’ financial parameters as of 31.12.2005 the market value of equity of Sanofi-Aventis is derived as follows:

Market Value of Equity Estimation - CT Approach

Market Value of Equity Estimation – CT Approach

The last step to complete the valuation process is to provide a weight for each valuation approach. DCF approach resulted in € 91,925 mn. CMM resulted in € 92,954 mn. and CT in € 100,999 mn. (press here for previous articles on DCF and CMM)

The final step of valuation is to give weights to each valuation method in order to determine the central value of the company.

CMM and CT approach will both receive equal weight of 25% while DCF will receive a weight of 50%. Therefore, the weighted market value of equity is calculated as follows:

Valuation Synthesis

Valuation Synthesis

It can be seen that the total weighted value of € 94,451 mn. diverges 10% from the actual market capitalisation of Sanofi (€ 103,656 mn.). As mentioned in Part 1 & Part 2 there are various reasons for the difference in derived values from various valuation approaches and the actual market capitalisation of a company (including: potential investors’ speculation, M&A rumors, imperfect information, short-term investments on companies’ stocks as opposed to DCF which is based on long-term free cash flows etc.)

It should be noted that the value derived is the central value. This means that sensitivity analysis was not performed to provide with a range of values. In DCF one could slightly alter the growth to perpetuity and WACC to see the potential effects on Enterprise Values. That would provide a range of values and in fact the actual market capitalisation value would lie in that range. Therefore, the derived value can be considered close to the actual market capitalisation meaning that the stock as of 31.12.2005 was not overvalued or undervalued and investors’ expectations about Sanofi-Aventis were realistic with respect to Sanofi-Aventis actual financial performance.

Valuation of Pharmaceutical and Biotechnology Companies: Comparable Multiples Method (Part 2)

In this article the Comparable Multiples Method (CMM) is discussed and analysed. CMM is based on a relatively basic principle; that the value of the target company (the company to be valued) can be derived through certain multiples (financial ratios) of similar (comparable) companies.

Step 1: Analysis of the Target Company

There are certain data that should be collected for the target. These are both financial and non-financial:

  • Non-Financial Data
    • Location: headquarters, countries of operation, location of subsidiaries.
    • Quoted Status: Publicly Listed or Private
    • Subsidiaries: number of subsidiaries, subsidiaries’ sector of operation.
    • Global Strategy: M&A, organic growth, future potential.
    • Product Pipeline: Number of products, breakdown of products’ type.
    • Number of competitors and potentially perform a SWOT and Porter’s 5 forces analysis as well as create a BCG matrix.
    • Market drivers and challenges.
  • Financial Data
    • Revenue structure: breakdown of revenues by area. For example, a company active in the Oil & Gas industry could segment its sales by type of product sold Natural Gas sales, Petroleum Sales, Bioethanol etc.
    • Cost structure: Where does the company spends its cash on compared to the industry? R&D, Marketing or Manufacturing?
    • Bench-marking of competitors and the target.

Step 2: Characteristics of Comparable Companies

The comparable companies should have similar Financial and Non-Financial Data (as in Step 1) with the target. At a later stage CMM will be applied on Sanofi, the meaning of “similar data” will be clearer and more specific.

Step 3: Collection of Financial Data and Multiples of Comparable Companies

There exist two different types of multiples. These are Enterprise Value multiples and Equity multiples.

  • Enterprise Value multiples: enterprise value (EV) is defined as Market Capitalisation + Net Debt (i.e. Debt – Cash). It is partially market-dependent (due to the market capitalisation component) but it has a significant enterprise specific element (net debt). The most commonly used EV multiples are EV/Sales, EV/EBIT, EV/EBITDA and EV/Free Cash Flow.
  • Equity multiples: these are multiples which are based on the market value of equity of the comparable company. PE ratio, P/Sales, P/Book Value and P/Operating Cash Flow are mostly used.

Step 4: Analysis

Before estimating the average and the median of the multiples above a careful consideration shall be given when ruling out outliers. Outliers are numerical values diverging from most of the sample. It should be noted that the median is estimated for ensuring that the sample is uniform (i.e. all outliers have been excluded, sample is converging). After analysing and deciding on the final multiples the market value of Equity and the Enterprise Value can be estimated based on the corresponding multiples and financial data of the target company (e.g. if  the average of P/Sales of the comparable companies has been estimated, then it should me multiplied by the sales of the target company to measure what its P is i.e. its market value of equity).

Example: CMM Valuation of Sanofi-Aventis (As of 31.12.2005)

In 2005, Sanofi-Aventis was particularly active in 3 main therapeutic areas: Cardiovascular (~10% of total sales), CNS (~20% of total sales), Blood (~15% of total sales) and Oncology (~10% of total sales). Using appropriate country filtering (U.S., Northern European and Japanese companies were included) and by searching through financials the following companies with similar revenue breakdown were identified:

 Baxter International
 Johnson & Johnson
 King Pharmaceuticals
 Mitsubishi Pharma
 Torii Pharmaceutical

By assessing the characteristics of the sample one could observe a number of problems. Firstly, comparable companies in terms of market size are missing apart from Johnson & Johnson, which however, has a large medical devices segment and could be considered non-comparable. For the purpose of this valuation, Johnson & Johnson will be included. The second problem is the size of the sample. The sample contains 6 companies which is sufficient only if it contains highly comparable companies.

In the table below the multiples of the comparable companies are shown. Highlighted in red are the outliers which have been excluded in the calculation of the average and the median (click on the picture to see the actual numbers more clearly).

Comparables Companies - Average Multiples

Comparables Companies – Average Multiples

The table below presents the process of estimating the total market value of Sanofi Aventis’ equity based on the derived transaction multiples. Net Debt has only been subtracted from Enterprise Value to determine the market capitalisation of the company as figures derived from equity multiples are market values of equity.

Market Value of Equity Estimation - CMM Approach

Market Value of Equity Estimation – CMM Approach

Using the CMM approach the market value of equity of Sanofi-Aventis as of 31.12.2005 was estimated at € 92,954 mn. The market capitalisation of Sanofi-Aventis was € 103,656 mn. (31.12.2005).


In CMM one collects a sample of comparable companies based on both financial and non-financial criteria. Equity and enterprise multiples are collected for the comparable companies and the average and median are calculated for the comparable companies and outliers are excluded. Thereafter, the average multiples are applied to the target company. Net debt has to be subtracted from the enterprise value derived from the comparable multiples, as equity multiples estimate the market value of equity and the aim is to compare these values to the actual market capitalisation of the target company.

Although a 10% deviation between the derived value and the actual market capitalisation of Sanofi-Aventis can be considered as huge when considering share price performance, CMM is highly sensitive to the selection of the sample and the average multiples. A difference in a decimal point in a high-weight multiple can have a large impact on the final value of the company.

The next article will focus on the Comparable Transactions (CT) methodology and provide an overall summary of the valuation results from the 3 methodologies (CMM, CT and DCF) on Sanofi.

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


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


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


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.



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.

Business models in the pharmaceutical industry: The case of Novo Nordisk

A business model demonstrates how a company delivers and captures value for its customers. It is one of the most significant factors determining the success of a company’s strategy, especially in the pharmaceutical industry. There exist various business models, which a start-up firm can choose for its short and long-term future. The main categories of business models are described below:

  • FIPCO: Fully integrated pharmaceutical company. These are companies that are active at all points of the value chain i.e. research, development, manufacturing and marketing/sales. A bright example of such companies is big pharma.
  • Partial integration: this includes companies that exist only at certain points of the value chain. For instance, early or mid-stage biotech companies are research driven and either outsource development and manufacturing processes or out-license their product. Contract Research Organisations (CROs) and Contract Manufacturing Organisations (CMOs) are also examples of such business model.
  • VIPCO: virtually integrated pharmaceutical companies. Such companies outsource almost all of the steps within the value chain. One of the most common examples of a “virtual” company is Shire Pharmaceuticals.
  • Collaborative models: partnering with other companies for drug discovery. Such model is a common example of value and risk sharing. A similar principle applies in a co-development model.
  • Biosimilar/generic: in such model the firm takes advantage of the patent expiry of branded drugs. It has to be noted however, that biosimilars differ from generics in the way that, biosimilars are required to prove their efficacy and safety. This primarily because, drug development and manufacturing of biologis is highly complex and therefore, biosimilar cannot be simple copies of biologics.
  • Technology brokering: using a strong network of clients for bringing together two or more companies for reaching a deal. These companies can be referred as service companies.
  • Follow-on (me-too) drug: developing a molecule that is already on the market but with new indication (Sabatier et al, 2010).

Novo Nordisk’s business model will be discussed in order to demonstrate how one can identify and analyse the business model of a company (Figure 1 shows the main financials of Novo Nordisk). Novo Nordisk is one of the industry leaders within the field of insulin delivery devices market. More specifically, Medtronic has 20% share of that market while Novo Nordisk and Sanofi have 16% and 15% of the sector’s market share, respectively (Global Information Inc, 2012). Thus, in order for the three key players to at least maintain their market share, they should have a growth rate equal or greater than that of the market overall.  One of the key characteristics of Novo Nordisk is its specialised R&D portfolio; both in the medical devices industry and the drug market the focus is on diabetes and insulin-related diseases. This characteristic can be perceived both as an advantage and a disadvantage. On the one hand, such specialisation may build a competitive advantage for the company as well as a brand over diversified organisations with multi-segment products and services. On the other hand specialised R&D, could be highly risky as it can make the company increasingly dependent on a specific market segment. For instance, if another entity discovers a product that can disrupt the diabetes market as a whole, then Novo Nordisk (or other “specialised” companies in that case) will be negatively affected. One way to compensate for such threat is forming strategic alliances and partnerships in which there is risk and value sharing. This is the point where the importance of business model becomes extremely significant.

Novo Nordisk Financials

Figure 1: Novo Nordisk Financials

It can be seen from Figure 1 that there is a significant trend between the percentage of sales coming from in-licensing with EBITDA margin, especially from 2009 to 2012. For this purpose, I have identified the majority of partnership agreements (including in-licensing deals) formed by Novo Nordisk (Figure 2). The first column indicates the year at which the agreement took place; the second column describes the type of agreement; in the third column I have determined the reason the partnership/alliance was formed or the stage at which the drug was in or out-licensed (where applicable); the fourth column describes the type of technology or drug that the agreement is related to.
Novo Nordisk Strategic Partnerships / Alliances

Figure 2: Novo Nordisk Strategic Partnerships / Alliances

The general conclusion that can be drawn from the analysis above is that two different strategies were pursued in the period of 1990s and 2000s:
1990 – 2000
•   In-licensed technology or granted access to different technologies that assisted Novo Nordisk in drug discovery and development.
•   Build brand name by marketing and distributing in-licensed products.
•   Avoided collaboration at pre-clinical stages with other companies.
2000 – 2012
•   Establishing in emerging markets, mainly India and Brazil by building/acquiring insulin manufacturing plants or through product co-development under local brands.
•   At the research stage Novo Nordisk seems to in-license promisingtechnologies instead of products (regenerative med., DNA binding technology, NGS) or make collaborations with the academia instead of with other companies.
A different way to formulate these results is shown in Figure 3:
Business Model of Novo Nordisk

Figure 3: Business Model of Novo Nordisk

In conclusion, the analysis above suggests that Novo Nordisk does not use a single business model. Having this in mind, one can assume that the business model of Novo Nordisk is a combination of a collaborative and a partial integration model. However, it is not possible to assume a business model that would perfectly reflect the reality. As a result of the technological progress in the healthcare sector and challenges that Life Science companies are currently facing, many companies have decided to develop a flexible and adaptive business model that may change depending on various internal and external factors. It would be interesting to see whether and how would pharma (especially big pharma) change its business model to overcome its challenges.

R&D Productivity: Winners and Losers

Measuring R&D productivity and innovation has been a historical issue in the pharmaceutical industry. From the concept of creative destruction developed by Schumpeter to the idea of disruptive innovation by Clayton Christensen, no one has been able to adequately define R&D productivity, especially innovation let alone quantify it. The pharmaceutical industry has suffered from lack of R&D productivity, often defined as a function of R&D costs, the overall approval rate, time frames (total number of years needed to bring a drug in the market) and the number of projects at hand (work in progress). As all of these factors increase the effect on R&D productivity is inverse, i.e. R&D productivity is declining.

However, there is a significant distinction between R&D productivity and innovation. R&D productivity is “easier” to quantify based on various R&D parameters and performance measures. Instead, innovation is conceptualised differently even within the same organisation. A shareholder would consider innovative a drug that captures maximum financial value in the sense that the end-users prefer that product instead that of a competitor. A scientist, a doctor or even a patient would consider innovation something that really changes lives, a huge switch that alters completely the current treatment paradigms. Therefore, the question still remains:

How would an organisation measure its innovative performance as compared to its competitors? The following metrics have been used historically:

  • R&D spending: The amount of money invested for research and development. It is an absolute number and since it is not relative to the company’s size it is an abstract measure.
  • R&D spending to sales (or else R&D intensity): The amount of money invested for research and development relative to a company’s sales. It is considered as a more accurate metric than R&D spending since it is a relative metric; it takes into account a size characteristic (sales) of the company. For instance, a mid-stage pharmaceutical/biotechnology company spends most of its cash on R&D and usually outsources the marketing/sales and manufacturing as it does not have the infrastructure to do so on its own. Instead, a fully integrated pharmaceutical company (FIPCO) spends slightly more of its costs on R&D than in marketing.
  • Number of NMEs: Number of new molecular entities approved can be an indication of the productivity of a company. However, their quality is considered more important than their quantity. In addition, a drug approved now shows how innovative the company was at the time of research and development and not at the time of approval. This time lag may misrepresent the effectiveness of a company’s productivity. Finally, a single company receives very few approvals in a single year and therefore, a slight variation (e.g. a company receives 3 approvals in a specific year but in the next year receives 2 approvals) does not show a variation in innovation as there are multiple factors to be taken into account (e.g. a company might receive a non-NME NDA approval that can be proved more innovative than another company’s NME approval in the same therapeutic area)
  • Number of pipeline products: indicative of the amount of products that will enter the market (if approved) in the future. Relative to R&D spending it makes it an efficient measure of R&D productivity.
  • Number of patents: In order for a company to be granted a patent, it has to show that its invention is useful, non-obvious and novel. The problem with number of patents as a metric of innovation is the huge time lag between the patent grant and the actual product. Also it is a combination of patents that leads to actual products and not a single patent. This, combined with the time lag involved makes it highly difficult to observe which patents have resulted in innovative products.
  • Sales or return on investment (ROI) from new products launched: Sales can hardly be considered as an indicator of innovation if the product does not add medical value or adds value only incrementally. New products launched can also be misleading if these products are not innovative. It can be however a measure of productivity.

The table below shows the relationship between the mean R&D spending to mean pipeline with mean EBITDA margin.

Mean pipeline to mean R&D (USD bn.) vs. Mean EBITDA margin (%)

Mean pipeline to mean R&D (USD bn.) vs. Mean EBITDA margin (%)

The mean R&D spending was estimated by firstly, deflating the real R&D values from 2000 to 2010 and then finding the 2000 to 2010 mean value of R&D spending. Mean EBITDA margin was estimated by averaging the EBITDA margin of all years (2000 to 2010).

The analysis above shows whether companies translate their number of products/average R&D spending to financial value. The following classifications have been made:

One-to-One Relationship: High number of pipeline to R&D spending (or conversely, low R&D spending per product) that leads to low EBITDA margin (similarly low number of pipeline to R&D spending with high EBITDA margin).

Productive: a company that has low R&D spending per product and achieves a high EBITDA margin.

Unproductive: a company that has high R&D spending per product but low EBITDA margin.

The Loser

Eisai’s R&D spending is not that high compared to its pipeline, however its EBITDA margin is particularly low. Eisai faced a patent expiration of its Alzheimer blockbuster drug, Aricept in 2010 which accounted 40% of the net sales of the company at that year. This is the possible explanation of Eisai’s underperformance.

The Winner

In opposite, Gilead Sciences seems the most productive company across the sample. Its high EBITDA margin is driven by its antiviral drug business and mainly HIV/AIDS drugs, Atripla and Truvada (which make up 3/4 of Gilead’s total revenues) which expire in 2018 (Europe) and 2021 (U.S.). In order to sustain its growth at least  pipeline products (5 are in phase I, 7 are in phase II, 7 are in phase III and 2 in approval/marketing) . Statistically, 0-1 of its phase I products, 1-2 of its phase II products, 4-5 of its phase III and 2/2 of its marketing/approval products can be approved (although a recent announcement by the FDA suggested that there will be a delay of the 2 products currently at the approval stage). Overall, it is expected that at the time of patent expiration of Atripla and Truvada drugs (at which time Gilead’s all other drugs will also have expired – as they have an earlier patent expiry date), Gilead Sciences will have 7-10 products in the market, 5 of which will be antivirals (HIV/AIDS). If Gilead’s revenues increase with a similar growth rate until 2019, its total sales will reach ~USD 28 bn of which ~USD 20 bn. will come from its antiviral business assuming Gilead maintains its focus on that specific area. In that case, USD 20 bn. will have to come from its 5 antiviral drugs that is expected to have entered the market by that time. It is however, unlikely for that to happen as it means that all 5 drugs will become blockbusters with average sales of USD 4 bn. To avoid the high risk of depending on very few blockbuster products, Gilead is more likely to diversify into new therapeutic areas through new acquisitions or increase its focus on its current, minor therapeutic areas by capitalising on the infrastructure of the acquired companies (Myogen and CV therapeutics acquisitions in cardiovascular area, Corus Pharma in respiratory area, Navitas Assets treatment for PAH, CGI Pharmaceuticals in inflammatory diseases, Arresto Biosciences and YM Biosciences in oncology area and Pharmasset in hepatitis C area).

What you invest is what you get

It can be seen that a major part of Big Pharma (Roche, Novartis, Eli Lilly,AstraZeneca, Bristol-Myers Squibb and Pfizer) is in the border between “PRODUCTIVE” and “1-1 RELATIONSHIP”. This means that pharma’s average R&D inputs lead to the average financial performance (EBITDA margin). This shows the life cycle aspect of these companies and more specifically their maturity. Their global presence and their huge infrastructure create several issues (including communication, lack of focus on or inability to identify key pipeline products if pipeline is full of other products).


If you find this article interesting do not miss the next one which will focus on a more qualitative approach related to the source of innovation in the pharma and biotech sector.

Regenerative Medicine Market: The future in Life Sciences or just another promise?

Regenerative medicine (RM) is one of the most innovative technologies that might prove to have a significant added value in healthcare. I will start with some scientific definitions and then move into the business area. RM is an interdisciplinary field involving tissue engineering and (stem) cell therapy. Stem cells are undifferentiated cells (i.e. they have not transformed to a specific cell type yet) with the ability to differentiate or self-renew. Progenitor cells have the capacity to differentiate but not self-renew.

In cell therapy ex-vivo cultured stem cells or progenitor cells are used to treat certain types of diseases.

In tissue engineering, scientists use scaffolds and growth factors to create new tissues (or repair damaged tissues) in the patient’s body. There exist three main treatment methods within tissue engineering: stem cell based tissue engineering, non-stem cell based tissue engineering and gene therapy. Stem cell based tissue engineering involves autologous stem cell therapy (e.g. cryopreservation of stem cells for transplantation – many people do that nowadays, when the baby is born) and allogeneic stem cell therapy (e.g. bone marrow transplantation). Accordingly, in non-stem cell based tissue engineering there is autologous and allogeneic (primary/progenitor) cell therapies. Non-stem cell based tissue engineering also involves xenotransplantation. Finally, gene therapy aims at providing tissue cells a suitable environment for the appropriate proteins to be expressed (potential applications: skin, cartilage or bone; Goessler et. al, 2006).

The advantages of each of these specific therapies vary, but in general these are: wide use as science progresses and treatment of previously non-treatable disseases. Disadvantages include: tissue or organ rejection from the body, adverse side effects and high costs.

The challenges that scientists are currently facing is the maintenance of the appropriate environment for terminal cells to expand (pH, temperature, metabolites and nutrients) as well as isolating homogeneous populations of differentiated cells.

Having discussed the problems related to the science of RM I will now move into the business promises and challenges of RM.

• High uncertainty: there is a high uncertainty regarding the therapeutic areas in which RM can be applied at. Literature suggests that orthopaedics and cardiovascular areas are the most promising for RM. Instead, diabetes and CNS remain at the bottom of the list.

• Large scale-up: most of the current treatments in RM are patient-specific and it is very difficult for biotechnology companies to do process scale-ups for these treatments. Therefore, only few hospitals (in high technology areas) are able to offer such therapies.

• Ethics and regulation: regulatory framework for RM is unclear as there is an extensive debate about its uses and applications (Bioethics).

• Costs: as an example an artificial heart valve may cost up to $1,000,000 for the patient and cryopreservation of embryonic stem cells can reach $2,000/year.

• High R&D costs: although the specific costs of RM have not been accurately identified yet, according to the costs for patient and hospitals one can conclude that R&D costs might be equal or even more than developing a drug.

Considering these challenges why would one invest in RM? To answer this question the market drivers should accurately be identified. The following business motives are the most prevalent for RM:

• Pressure for lower health-care costs: As discussed above there are high costs both for companies as well as for patients. However, many believe that as science progresses and time passes the law of “economies of scale” will apply and RM applications will become less expensive than traditional treatment methods.

• High academic research activity: Academia is undoubtedly the protagonist in the progress of RM. There are numerous PhD fellowhips in the field of RM and universities are also offering master degrees in the field of RM. A few years ago this would seem very distant. This involvement of academia has attracted both public organisations (for example the technology strategy board in the UK) and healthcare companies by becoming active investors in the field. On one side, public organisations believe that RM can have a significant added value in medicine and for the treatment of serious diseases, while healthcare companies expect RM –in the long-term- to compensate on the challenges that these companies face (especially big pharma – rising R&D costs, low market growth and patent expirations)

• High demand for organs

• Involvement of big pharma: Big pharma is getting increasingly interested in the field of RM. This interest may be just exploratory (challenges faced by Pharma companies may prevent them from getting intensely involved in other uncertain areas in which they are not familiar) or real (RM offers pharma companies to use stem cells for drug screenings. Also, RM offers a promising diversification of existing business models.)

• Technological innovation in other high-tech areas: for example nano-medicine.

According to my short market analysis, there are currently 50 companies listed in the stock-market that are related to RM of which the top 3 companies have a market cap US$ 2 bn, US$ 1 bn and US$ 600 mn while the rest of the companies have a market cap below US$ 240 mn. Moreover, 34 out of the 50 companies listed, have so far been making losses. But it was the same situation for biotech companies few years ago and pharma realised (with a delay I would say) their huge potential through acquisitions, strategic alliances and partnerships. Could RM be the same? I say we will have to wait. It is important to note however, that the compound annual growth rate (in terms of revenue) of the 50 listed companies (in total) is approximately 16% (from 2007 to 2010).

In conclusion, the scientific progress of RM, the increasing involvement of academia as well as big pharma and the approval of the first stem cell drug Prochymal (for the treatment of graft-versus host disease – produced by Osiris inc,) by the FDA makes me to believe that RM is in the right way and will eventually deliver on its promises.

Oncology Market: Drivers and Challenges

As pharma celebrates its 16-year high NME approvals, productivity of certain disease areas including oncology certainly fall behind. Oncology diseases are the most complex in terms of research and development. At the research stage, target identification has been a major challenge due to the high toxicity of potential drug candidates. At the development stage, pharma has failed to add significant value in terms of safety and efficacy. Complexity of cancer diseases is proven by the low approval rates as opposed to other therapeutic areas (Figure 1; Kola and Landis, 2004).

Figure 1: Success rates – Oncology vs. All therapeutic areas

Figure 1 shows that the overall success rate of Oncology drugs is half of that of all other areas (on average). Although oncology approval rates are low, according to IMS Health oncology market has the largest share compared to other disease areas ($US 42 bn, ~7% of global pharma market) with compound annual growth rate (CAGR) of 10,5% (Figure 2).

The global market for pharmaceuticals (all areas) is estimated to experience a CAGR of 6.3% (Figure 3). Prescription drugs that were active in the market between 2007 and 2011 were found to be ~5,700 in number. Similarly, the number of oncology drugs was ~500.

Figure 2: Global Oncology Market (2007 - 2011)

Figure 2: Global Oncology Market (2007 – 2011)

Figure 3: Global Pharma Market (2007 - 2011)

Figure 3: Global Pharma Market (2007 – 2011)

Aggregate sales (in period 2007 to 2011) for oncology and all therapeutic area drugs was US$ 262 bn and US$ 3801, respectively. This results in average sales per product for oncology drugs US$ 524 mn (aggregate sales / # of products active in the market) and for all drugs $US 668 mn. Assuming even sales each year, oncology drugs achieved, on average, sales of $US 105 mn (per product per year) while other drugs, sales of $134 mn (per product per year).
The analysis above shows that both R&D and market productivity for oncology drugs is lower than other therapeutic areas. In addition, a thorough analysis from EvaluatePharma shows the oncology market outlook in 2014. What is interesting, is the dominance of Roche (with Genentech) in the market as well as AstraZeneca’s and Sanofi’s market share shrinking (projected – see figure 4).
Why does pharma continue to get involved in oncology? There are several market drivers that attracts  are:
  • Cancer prevalence: The main reason that the market is growing faster than other areas. Increased cancer prevalence is associated both with population growth as well as with increased life expectancy.
  • Early diagnosis: Due to emergence of advanced imaging techniques and computer simulations it is diagnosis has been more efficient and diseases can be detected earlier.
  • Academic collaborations and partnerships: Pharma and biotech companies, in order to reduce both the high R&D costs and risks related to cancer drug discovey, they form strategic alliances and partnerships with private academic institutions or funds. A high amount of government funded institutions are also involved in such deals. This is a major driver in the field of oncology.
  • Biotech: externalisation of R&D is becoming a major trend in pharma. Oncology drugs are commonly co-developed than developed in-house (due to their high R&D costs). Almost half of the drugs that are developed in-house at the preclinical stage, they end up as (out)licensed or co-developed at a phase III. In addition
  • Blockbuster presence: Although oncology drugs’ sales per product are lower than overall drug sales, approximately one sixth of blockbuster drugs are focused on cancer diseases, implying that oncology market profile is skewed towards high sales drugs. This makes oncology market more attractive for pharma companies.
  • Duration of treatment: As in other disease areas, drugs have succeded in extending patients’ life and therefore prescription of medicine is increased.
  • Emergence of targeted therapeutics
Apart from the attractive characteristics of the oncology market, there are also some challenges, including:
  • Cost containmentState funding for all industries has been reduced (U.S. and Europe) the past few years due to the financial crisis that has affected all areas including healthcare. As an example, the National Insitutes of Health (NIH) reduced R&D budget (compared to last year) for the first time in its history. This shows the efforts made to stabilise the upward trend of R&D spending. Moreover, the US$ 85 bn cut implemented by the US government is expected to decrease NIH spending by approximate 5% in 2013.
  • Barriers to entry: Lower approval rates for oncology drugs, makes the market of oncology riskier and more costly, raising barriers for new entries
  • Patent Cliff: Patent expirations between 2010 and 2014 put at risk at least US$ 100 bn and major oncology drugs are at stake.

Licensing agreements have proved to be more efficient from both a strategic and financial point of view, especially when it comes to oncology. A licensing deal made at a late stage will have high upfront values and low (development) milestones (high probability of approval). Instead a licensing deal involving a product at an early-stage will have a lower upfront value and higher milestones (low probability of approval).  Therefore, there is a reduction of value loss compared to the event where a company executes a project on its own. From a strategic point of view, every-day decision making and managers’ time and effort dedication (of the licensee firm) to clinical trial projects is not destructed, since only financial compensation is granted to the licensor depending on the outcome.

In my view, there are two ways to cope with the challenges of the oncology market. The first one is licensing agreements (as discussed above) which may make pharma companies more efficient by capitalising on biotech’s leading technology research platforms and scientists’ expertise. This suggested solution can reduce the effect of cost-containment as well as the major patent cliff faced by the pharma industry. The second solution would be to better understand oncology diseases and their complexity. This could only be achieved through a deeper dedication to research (drug discovery) in order to arrive to more optimised leads, which in turn it may result in more promising drug candidates.

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.