Evaluating a Biotech Company Using Basic Math
To evaluate a biotech company with no revenues, we follow a step-by-step process to estimate peak sales, forecast cash flows, and apply a discount rate. Below is an explanation of the process:
1. Estimate Total Peak Sales
The first step is to estimate the peak annual sales the drug could generate once it is successfully launched. This is done by analyzing the target market size, expected market share, and the estimated price of the drug.
Example Calculation
Suppose the biotech company is developing a cancer drug. Here’s an example estimate:
- Target market size: 100,000 patients per year
- Estimated market share: 25%
- Price per treatment: $100,000
The estimated peak sales would be calculated as:
Peak Sales = 100,000 x 0.25 x 100,000 = 2.5 billion dollars per year
2. Forecast Total Revenues Minus Costs Over 10 Years
Next, forecast the total revenues over a 10-year exclusivity period and subtract the associated costs (such as manufacturing, distribution, and marketing) to get the net profit.
Example Calculation
Assume the following:
- Annual peak sales: $2.5 billion
- Cost of goods sold (COGS): 30%
- Marketing and other expenses: 20%
This gives a profit margin of 50%. The annual profit is calculated as:
Annual Profit = 2.5 billion x 0.50 = 1.25 billion dollars per year
Over 10 years, the total revenues minus costs (net profit) would be:
Total Revenues - Costs = 1.25 billion x 10 = 12.5 billion dollars
3. Apply a Discount Rate to Cash Flows
Now, apply a discount rate to account for the investment risk. Biotech companies typically carry a higher risk, so the discount rate might be between 10-15%. In this example, we use 12%.
The present value (PV) of the future cash flows is calculated using the formula:
PV = Cash Flow / (1 + r)^n
Where r is the discount rate (12%) and n is the number of years.
Example Calculation
To simplify, the total present value of the 10-year cash flow can be calculated using the net present value (NPV) formula for constant cash flows:
NPV = 1.25 billion x (1 - (1 + 0.12)^-10) / 0.12 = 7.11 billion dollars
4. Risk-Adjusted Net Present Value (rNPV)
Since there is a risk of clinical trial failures or regulatory hurdles, we adjust the NPV based on the probability of success. If the drug is in Phase 2 trials, the success probability might be around 30%.
Example Calculation
The risk-adjusted NPV (rNPV) is calculated by multiplying the NPV by the probability of success:
rNPV = 7.11 billion x 0.30 = 2.13 billion dollars
This is the expected value of the drug based on the information available and the risk factors.
Conclusion
By using this approach, we have estimated that the risk-adjusted net present value (rNPV) of a hypothetical biotech drug with a $2.5 billion peak sales potential could be around $2.13 billion. This method helps determine if the potential future earnings justify the investment, even for biotech companies with no current revenue.
Evaluation of Arcturus Therapeutics HoldingsEvaluation of Arcturus Therapeutics Holdings(Ticker symbol:ARCT)
This evaluation considers the process of estimating the potential value of Arcturus Therapeutics Holdings using forecasted revenues, costs, and risk-adjusted net present value (NPV). The following steps explain the process in detail:
1. Estimate Peak Sales
Peak sales represent the maximum yearly revenue the drug can generate once it is fully commercialized. To estimate this, the following factors are considered:
- Market size: The target population for the drug.
- Drug pricing: How much the company will charge for the drug.
- Market share: The portion of the market the company expects to capture.
For example, if the drug targets a rare disease affecting 100,000 people worldwide, priced at $10,000 per patient, and the company captures a 70% market share, the estimated peak sales can be calculated as:
Peak Sales = 100,000 patients * $10,000 per patient * 0.70 = $700 million annually
2. Forecasting Total Revenues Minus Costs Over a 10-Year Exclusivity Period
Most biotech drugs enjoy a 10-12 year exclusivity period. The total forecasted revenue over this period considers the growth of sales to peak levels and the associated costs (R&D, manufacturing, marketing, etc.).
Assuming the drug reaches peak sales of $700 million in the third year, and grows at 10% annually before plateauing, the forecasted revenue might be:
- Year 1: $100 million
- Year 2: $500 million
- Year 3-10: $700 million per year
Total revenue over 10 years can be calculated as:
Total Revenue = 100 + 500 + (700 * 8) = $6.2 billion
Subtracting costs, which are assumed to be 40% of revenues, we get:
Net Revenue = 6.2 billion * (1 - 0.40) = $3.72 billion
3. Apply a Discount Rate Based on Investment Risk
Given the high risks associated with biotech companies, a higher discount rate (typically 10-20%) is applied to future cash flows to account for risk. We assume a discount rate of 15%.
The Discounted Cash Flow (DCF) for each year’s revenue is calculated using the formula:
DCF = Future Cash Flow / (1 + r)^n
Where r is the discount rate (e.g., 15%) and n is the number of years in the future. For example, for year 3:
DCF (Year 3) = 700 million / (1 + 0.15)^3 ≈ 456.7 million
4. Risk-Adjusted Net Present Value (NPV)
The NPV is calculated by summing the discounted cash flows (DCFs) for each year of the 10-year forecasted period. The total DCF gives us the risk-adjusted value of the future cash flows:
NPV = DCF (Year 1) + DCF (Year 2) + ... + DCF (Year 10)
Assuming the total DCF over 10 years sums to approximately $2 billion, this is the risk-adjusted NPV of the investment.
Conclusion
By following this process, the risk-adjusted net present value for Arcturus Therapeutics Holdings’ drug pipeline is approximately $2 billion. Investors compare this NPV against the company’s current market valuation to determine whether the investment opportunity is attractive.