The science and business of biotechnology is complex and uncertain, and trying to figure out biotech companies' prospects for success no easy task. Many biotech companies are in the development stage and, with little or no cash flow, earnings or even revenues, they often confound traditional financial analysis. (To learn more about the industry, check out The Ups And Downs Of Biotechnology.)

TUTORIAL: Investing 101

Putting numbers on a biotech firm – while not entirely impossible – can be awfully tricky. So, when sizing up a biotech company's strategic and financial health, analysis often relies heavily on qualitative analysis rather than quantitative, financial methods of valuation. Here are a few non-numerical items to consider when analyzing biotech companies.

Products and Pipeline
Naturally, a biotech company's product portfolio and research pipeline are the lifeblood of its success. That means you need to take a close look at the company's key products and the features of its biotechnology. Ideally, the company should be developing a technology platform with multiple – rather than single – treatment opportunities. Importantly, the company should be working on a large number of products that target diseases with large patient populations.

Watch out for biotech firms developing products for big treatment areas – such as cancer, and cardiovascular diseases and central nervous system disorders – where potential return in investment is greatest. Stay clear of companies developing "me-too" treatments for disease areas that already well served by existing technologies in the market.

At the same time, find out where the company's products are situated in the development pipeline. The later the product's stage of clinical development, the greater the chances of regulatory approval, market launch and commercial success. (For more on the connection between research and profits, read R&D Spending And Profitability: What's The Link?)

Patents
A biotech company's technology and products might have great potential, but does the company possess patents to protect its technology? By giving the biotech company exclusive rights to its technology, patent protection increases the value of the technology and the company. The company can pursue R&D and commercial development with less fear of competitors "stealing" or infringing on their technology. Most importantly, patents can attract royalties-paying commercial partners with the financial clout to fund R&D, clinical trials, product development and marketing.

R&D
Does the company have a track record of productive research and development? Mature biotech companies spend about a fifth of total revenue on R&D, while early-stage biotech ventures typically spend well in excess of hundred percent of revenues on R&D. Not surprisingly, the outcome of R&D spending can vary wildly, especially for early stage biotech ventures.

A key factor in success is the ability to develop cost-effective drugs that represent breakthrough therapies. R&D that delivers similar results to those already on the market is less likely to translate into successful products. Look for companies with R&D programs focused on diseases that aren't currently well-treated. (To learn more about the research and development process, check out Buying Into Corporate Research & Development (R&D).)

Management
Talent and experience of management is critical for long term success. Ideally, the biotech company should be run by executives who have developed and commercialized treatments before. It's a good idea to look for management teams with a track record of meeting publicly-stated goals and development milestones. Meanwhile, be wary of companies that regularly miss their targets. Executives must have an excellent understanding of the clinical and commercial development process, appreciate the costs involved, and have a record of putting company's resources into projects that offer high returns on investment.

Partnerships
These days, biotech companies can rarely succeed alone. Given the big costs of drug development, a biotech company will be held back from reaching its full potential unless it can find partners to help fund clinical trials and commercialization. So, it's important to find out if the company has secured promising collaborations and licensing partnerships.Look for partners that show lasting commitment – remember, the biotech product development process can be a very long and expensive one. Also, keep an eye on deal terms as they offer a reliable indication of value that the market gives to the technology. A good licensing partnership agreement will include not only a generous royalty rate on future sales but also healthy upfront payments plus milestone payments for achieving development targets. (Management can play a huge role in a company, for more read Evaluating A Company's Management.)

Financial Resources
Finally, it's important to know whether the company is well-financed. After all, funding is the fuel of the biotech industry. Without funding, a biotech company will be forced to cut back on R&D, and clinical and commercial activities – reducing its chances of maximizing return on investment.It's reassuring to see enough cash on the balance sheet to cover expenses for at least a year or two. A solidcash position means that the company can strike up favorable partnerships without having to accept the first deal on offer. Of course, the hope is that the biotech company won't have to rely on external financing and cash reserves to keep R&D and commercial development going and will eventually be able to run profitably from high margin revenues.

The Bottom Line
It's almost impossible for the average investor to grasp the science that underlies biotech companies and their development projects. Given that biotech businesses typically have scant financial records, quantitative analysis represents a big challenge for investors, too. That said, looking at the key qualitative drivers of biotech value – namely a promising product pipeline, patents, talented management, durable partnerships and access to funds – offers a good first step in sizing up biotech potential. (For more on biotech, check out A Primer On The Biotech Sector.)

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