Karl Keegan heads the European Biotechnology research team at UBS Warburg in London.
Before that, Karl was a biotechnology analyst at Dresdner Kleinwort Benson, and a researcher at SmithKline Beecham Pharmaceuticals.
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The valuation of biotech companies is fraught with difficulty.
The diverse nature of biotech business models, the relative newness of the company, the lack of many tangible assets, the limited financial histories available and the spectacular growth forecasts make any such attempt demanding. As such it is almost impossible to get the balance right between quantitative and qualitative analysis.
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There is no one 'correct' way to value the sector.
Various valuation tools can be used to assess the potential, products and/or technology of a biotechnology company. There is no one correct way to value the sector, given the diversity of the companies under examination and the markets in which they operate . We assess the quality of the management (and their ability to do deals), the potential of the company and the quality of the science and technology underpinning its business.
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Use all the quantitative methods at your disposal.
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Comparable company analysis (either EV/revenue or EV/EBITDA)
Pros - it provides an idea as to what investors are prepared to pay.
Cons - it's crude and there are few true comparators.
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Discounted future earnings (EBITDA in 2005, for example)
Pros - it's EBITDA-based, so few assumptions are needed.
Cons - it's very dependent on the discount rate used.
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Discounted portfolio valuation (of the product pipeline)
Pros - it's good for early stage companies and current drugs.
Cons - it underestimates the value of more mature biotechs.
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Discounted cash flow (for the mature, profitable companies)
Pros - it's the most fundamental valuation methodology available.
Cons - it overvalues early stage companies and is heavily dependent on exit multiple/terminal growth rates.
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Forget tech. Focus on the people.
Management continues to be a key, if not the most important, variable in determining the success of a biotechnology company. Sustainable success can only be achieved by those companies led by individuals who can manage risk and not merely avoid it. Understanding the risk profile of drug development is a key attribute of the successful manager.
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Watch out for news flow.
The sector is very sensitive to the impact of news flow, thus contributing to the volatility in share prices. The absence of financial parameters increases this sensitivity. 'Buy on the rumour, sell on the news' is not too far from the truth.
News flow is comprised of clinical, scientific and financial press releases. However, the nature of scientific endeavour is leaky at best, and this feeds the city rumour mill, in addition to the growing number of internet bulletin boards . Furthermore biotech is now media-friendly - witness the huge number of articles in 2000-2001 detailing the progress and politics of the mapping effort and the personalities behind it. The downside of this was that genomics became a buzzword that too many companies tried to use in their positioning, and the term became commoditised.
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Understand the technical risks.
To be successful, a drug has to make it through clinical trials and a regulatory process. The level of risk you take as an investor is partly linked to the stage of clinical trials that a drug is in, but also to whether the concept and any drug based on that concept is proven 'in man'.
For instance, Genset's anti-obesity drug, Famoxin, is an entirely new concept. To date, the only direct proof of its efficacy is the reduction of weight in mice fed on a fatty diet. The only evidence to support it being successful in man is the existence of a famoxin- deficient obese population in man. This does not make it any less exciting or interesting “ but it does make it higher risk.
By contrast, the anti-TNF approach to modifying rheumatoid arthritis is well established, with the anti-TNF drugs currently on the market having sold in excess of US$1bn collectively in 2000. As such, anyone developing another TNF binding protein can be sure that the approach has a high chance of proving efficacious. Here, the technical risks relate more to side effects than efficacy.
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Understand the commercial risks.
Investors need to focus as much on commercial success as technical probabilities. Ultimately, technical risks can be reduced to a binary decision: is the drug approvable or not? In contrast, the commercial risks are much broader and consist of a spectrum of possible outcomes .
Is there room for five similar products on the market?
Does a latecoming product have the technical superiority, or the marketing power behind it, to make a dent in the market-share of a first-to-market product?
Does the biotech company have a GP sales force or the resources to create one?
Can it license its product to another company which has the right marketing channels?
With biotech, as with other industries, the product itself is only half the story. To be successful the company needs a mix of commercial strengths too. And the particular obstacles it has to overcome will depend in part on the therapy area it is launching its drugs into.
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Recognise the different types of biotech business.
All financial investors want to maximize return while minimizing risk, but they differ in their tolerance of risk. Biotechnology can be arbitrarily split into companies that have a platform model, a therapeutic focus, or a hybrid of both. The risks and rewards associated with each are mapped in the table below.
| | Platform technology  Hybrid  Therapeutics |
| Risk | low/medium | balanced | high |
| Revenue generation | near term | near term | medium/long term |
| Upside potential | low | high | low |
| Revenue stream | consistent | consistent | lumpy |
| Break even | near to medium term | medium term | long term |
Hybrids usually combine the technology platform approach with a product story in an attempt to maximise reward and minimise product-specific risk.
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View cash as a tool, not as an indicator of value.
Cash is irrelevant in valuing an ongoing business, because the likelihood of management giving it back to you is very remote. The fact that many biotech and internet companies trade at or below the value of their cash reserves reflects the fact that as they develop their businesses they burn cash, and there is an appreciable risk of them running out of cash before revenues flow. Cash can give an investor comfort as to how much life there is in a company ahead of the next financing but it should be viewed as a tool that the company is expected to use by transforming it into value added technologies/pipeline advancements.
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Don't be fazed by the technology.
Biotechnology by its very nature is technical but it is not overwhelmingly so. A common danger for both investors and analysts is to become overly fixated on the technology/drug in question. It is really important that investors be able to step back and look at the company in terms of a sustainable model. Of course there are issues and instances where a certain level of expertise will be required but in the main, biotechnology can be assessed by using common sense. Does the business model make sense and can management deliver on its promises?
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Be careful not to check in to the Roach Motel.
"You can check in but you can't check out" neatly summarises the issue of liquidity for biotechnology stocks. It is almost always possible to buy stock if you wait long enough, but selling stock can be a much more difficult issue. Liquidity and market capitalisation are two key checks that investors should assess very early in their decision making.
