Valuation Techniques: Discounted Cash Flow, Earnings Quality, Measures of Value Added, and Real Options

CHAPTER 23

REAL-OPTIONS VALUATION FOR A BIOTECHNOLOGY COMPANYa

David Kellogg and John M. Charnes

Many companies in the biotechnology industry have significant valuations despite having no product revenue because their products are in early stages of development. In the past 10–15 years, investors have bid up the stock prices of companies showing promise of developing a blockbuster drug. We explain the decision-tree method and binomial-lattice method (which adds a growth option) and use them to value a biotechnology company, Agouron Pharmaceuticals, as the sum of the values of its drug-development projects. The growth option was added because the development of an initial new molecular entity (NME) is similar to purchasing a call option on the value of a subsequent NME. We compare our computed values of Agouron with actual market values at selected points in time during the development of Agouron’s Viracept, a drug used to treat HIV-positive patients.

Much of the value in the early stages of a pharmaceutical project is contained in the promise that a blockbuster drug will result. In the biotechnology industry in particular, many companies have significant valuations long before they earn any profits from selling their products. In the past 10–15 years, investors have bid up the stock prices of many biotech companies, and their prices have remained high relative to their discounted cash flow valuations. This phenomenon is surprising to many market observers because some authors ...