While company valuations are critical to those of us who work with a particular company in a particular industry, few of us really take the time to consider or understand how a company valuation is conducted.

This is why I found Ben McClure’s recent article Using DCT in Biotech Valuation to be of particular interest.

In his article, McClure concedes that valuation can “appear to be more guesswork than science” but asserts that a generally accepted approach does exist to biotech valuation, which relies on discounted cash flow (“DCF”) analysis.

McClure writes:

Using DCF analysis, you can determine what someone would be willing to pay for that drug portfolio. In other words, you determine the forecasted free cash flow of each drug to establish its separate present value. Then, you add together the net present value of each drug, along with any cash in the bank, and come up with a fair value for what the whole company is worth today. A biotech company can have dozens, or even hundreds, of drugs in its developmental pipeline. But that does not mean you should include them all in your valuation. Generally speaking, you should only include those drugs that are already in one of the three clinical trial stages.

McClure goes on to explain that the next step is forecasting the sales revenue from each biotech company’s drugs, stating:

The key is to determine what expected peak sales would be if- and this is a big “if” -a drug successfully makes it all the way through clinical trials. Normally, you will forecast sales for the first 10 years of the drug’s life.

To do this, of course, requires one to make assumptions about the drug’s market potential and the drug’s potential market penetration. After the market size has been established, an estimated sales price has to be determined. McClure writes:

[P}utting a price tag on a drug that addresses an unmet need will involve some guesswork. But for a drug that will compete with existing products, you should look at the price of the competition. . . . Multiplying that price by the estimated number of patients gives you estimated annual peak sales. The biotech company won’t necessarily recieve all of this sales revenue. Many biotech firms-especially the smaller ones with little capital-do not have sales and marketing divisions capable of selling high volumes of drugs. They often license promising drugs to bigger pharmaceutical companies, which help pay for development and become responsible for making sales. In return the biotech receives [a] royalty on future sales.

McClure then explains that costs must be estimated as well as risks, and then the drug’s expected ten year free cash flows must be discounted to determine their present value. Finally, McClure writes:

Once you have gone through all of the steps outlined above to calculate the discounted cash flow for each of the biotech firm’s drugs, you simply need to add them all up to get a total value for the firm’s drug portfolio.