Pharma Valuation: Critical Factors for Capturing Value

Valuation is a frequently employed practice in the pharma industry. It plays a pivotal role in a multitude of decision-making processes including new product planning, opportunity assessment, fund raising, investment, licensing, partnering and M&A. In this article, we address some of the critical aspects that must be considered when conducting valuation of pharmaceutical companies and their assets.

Understanding the Context

The exercise of pharma valuation begins with a step that is often overlooked yet fundamental: understanding the context in which the valuation is to be performed. This is a prerequisite, as it lays the groundwork for the entire valuation process, affecting its methodologies and assumptions.

Given the varied purposes of valuation, each scenario necessitates a different approach. Imagine a scenario where valuation is conducted for capital raising. In this instance, the value proposition of the company’s products becomes the focus, in order to showcase the firm's potential to prospective investors. An integral part of this assessment also involves exit values, which are crucial to investors as it reveals the potential return on their investment. The context varies again when we look at the valuation for a go/no-go decision-making. Here, the emphasis is on the viability and profitability of a particular product or strategy or project, and the valuation should reflect such metrics.

Similarly, when a company is preparing for an Initial Public Offering (IPO), valuation tends to focus on similar companies that have been recently listed on a stock exchange. On the other hand, a valuation conducted with mergers and acquisitions (M&A) in mind will employ a different strategy. Instead of focusing purely on the company's individual potential, the emphasis here would be on synergies and strategic fit.

Lastly, consider the scenario of damage assessments and litigation. Here, the emphasis of valuation would be on quantifying the financial impact of a particular event or action on the company- it could involve assessing the loss to the company due to infringements in Intellectual Properties (IP), breach of contracts etc. Being aware of the context of valuation helps to guide the choice of methodology, assumptions, and key areas of focus, thereby leading to a meaningful valuation.

Appropriate Valuation Methods

Assessing the real value of a pharmaceutical company is as much an art as it is a science. There's a plethora of valuation methods, each with its strengths and weaknesses, tailored to different contexts. The ability to leverage these methods, and understanding when to apply each, is a crucial aspect of pharma valuation.

Among the commonly used approaches are Net Present Value (NPV) analysis, Risk-Adjusted NPV (rNPV) analysis, Real Options, Comparable Trading analysis, and Precedent Transactions analysis. Each of these methods serves a distinct purpose and selecting the most appropriate one can significantly reflect the true value.

Imagine assessing the long-term value of a stable pharmaceutical company. Here, the NPV analysis, a Discounted Cash Flow (DCF) based method, is most suitable. It gives a realistic estimation of the value considering the relative stability of the business. However, when the probability of success dramatically influences the value – as is often the case with pharma companies engaged in novel research – rNPV analysis reigns supreme. This approach adjusts the NPV by the likelihood of success, offering a more accurate estimation of the value.

In a scenario, when a company is preparing for an Initial Public Offering (IPO), comparable trading analysis is most appropriate. It serves to determine the market value by comparing the business to similar publicly traded companies. Likewise, for mergers and acquisitions (M&A), comparable transactions analysis is likely to be appropriate – the method evaluates the value based on precedent similar transactions. Selecting the right method and triangulating using multiple methods is the cornerstone of successful pharma valuation practices.

Customization of Assumptions

In the practice of pharma valuation, the importance of underlying assumptions is paramount. These factors significantly influence valuation - therefore, the key is to make assumptions which models the reality of the business, effectively captures the unique attributes and intricacies of the asset, asset-owning company, market and the wider industry.

An example of this is observed in the application of revenue growth projections and discount rates in the valuation process. These variables should be based on a comprehensive understanding of prevailing market conditions, the asset's growth prospects, and the overall macroeconomic conditions.  Similarly, consider the case of terminal value assumptions in the pharma industry - one might project a company's growth in perpetuity, or alternatively model its acquisition by a different entity. Both scenarios are realistic and materially impact the valuation, and thus, highlight the necessity of assumptions to be reflective of the reality of the business.

Moving Beyond Templates

A common shortcut in the practice of pharma valuation is the usage of predefined templates. These can be past valuation spreadsheets or websites where one can plug-in a few numbers to obtain value. Such templates are good starting points, but certainly not optimal valuation solutions. Given the unique nature of each pharma asset, meaningful valuation requires a more bespoke approach - it is wise to comprehend the fundamentals of the pharma asset under consideration, the market it seeks to play in, the competitive landscapes, and the key valuation drivers, and adjust the model accordingly.

Risk Factors Considerations

Considering risk factors associated with the asset, business and industry is vital to any pharma valuation exercise. The risk factors and their level have a significant impact on valuation and the ensuing decision-making.

For instance, when fund raising, potential investors often require a higher return on their investment to offset risks. This increased risk may be factored into the valuation through a higher discount rate or adjusted earnings projections.  Another effective approach is to construct different scenarios that represent various business cases, which helps in estimating the value while considering the potential uncertainties. By incorporating risk factors that are specific to the business cases, a realistic assessment of the value can be obtained.

Pharma Industry Idiosyncrasies

The pharma industry has unique characteristics that set it apart from others, making a deep understanding of its intricacies essential for accurate valuations. Unlike many other industries, the pharmaceutical industry is marked by significant research and development (R&D) expenses. Developing new drugs and treatments requires substantial investment, which impacts the valuation process. Valuation exercises must consider these high R&D costs and factor them in their assessments. The pharma assets have limited shelf life - unlike durable goods, pharmaceutical products have a finite period of market exclusivity. This time-bound nature affects the valuation process, as the potential revenue streams associated with the products are limited to the market exclusivity time window. Intellectual property (IP) issues also impact the valuation of pharmaceutical assets - patents are critical in the industry, as they grant market exclusivity and protect innovation. Valuations must consider the duration, strength and enforceability of the asset's IP, as they directly impact revenue and in turn, value.

Strong regulatory control is a salient feature of the pharma industry. Before a drug can be marketed, it receives approval from regulatory bodies. Pharma valuations must account for the uncertainties and complexities associated with navigating the regulatory hurdles. Similarly, clinical data plays a central role in the valuation of pharmaceutical assets - the efficacy and safety of drugs are primarily evaluated through clinical trials and studies. Valuation requires a deep understanding of the disease area being targeted, the underlying scientific principles and clinical data- they allow the assessment of the market potential of the asset considering factors such as treatment outcomes, evidence in support of outcomes, differentiation vs competitors and, thus likely uptake.

Additionally, the pharmaceutical industry is often characterized by access-related issues - factors such as pricing and reimbursement policies, healthcare system dynamics, and patient affordability come into play.  Despite having such high barriers to market entry, there is ample competition in the pharma industry, and monopoly seldom exists, thus requiring a robust understanding of current and future competitors is vital for valuation exercises. To sum up, valuing assets in the pharma industry requires more than just a generic application of accounting, economics and finance - pharma industry idiosyncrasies must be incorporated in valuations to derive meaningful value.

Related Readings

• Pharma Biotech Valuation: Best Practices
• Pharma Biotech Valuation: The Discount Rate Conundrum
• Terminal Value Issues in the Valuation of Pharmaceutical Assets
• Practitioner’s Pharma Valuation Guide

About BiopharmaVantage

BiopharmaVantage is a boutique healthcare consulting firm that specializes in providing valuation services specifically for the pharmaceutical sector. If you would like to explore how we can assist you, then please contact us.