The biotechnology business is complex and uncertain. Trying to figure out which biotech companies will succeed is no easy task. Because many ventures are in the development stage and lack cash flow, earnings or revenue, traditional financial analysis isn't much help.
When sizing up a biotech company, many investors rely on qualitative analysis rather than quantitative methods of valuation. Below, we discuss a few non-numerical items to consider when analyzing biotech companies.
- Traditional financial analysis isn't much help when gauging the prospects of biotech companies, because many are early stage and lack cash flows, earnings or revenue.
- Instead, investors should look to qualitative drivers, such as whether the company has a promising product pipeline, patents, talented management, and durable partnerships.
- That said, examine the company's cash position. Having a strong balance sheet means the company can continue to invest in R&D and won't be forced to accept a partnership on unfavorable terms.
Products and Pipeline
A biotech company's product and research pipeline are the lifeblood of its success. 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 and conditions with large patient populations.
Look for biotech firms developing products for big treatments where the potential return on investment is greatest, such as such as cancer, cardiovascular diseases, and central nervous system disorders. Stay clear of companies developing "me too" treatments for diseases that are already well served by existing medicine.
Also, 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.
A biotech company's technology and products might have great potential, but does the company possess patents to protect its technology? By giving the firm exclusive rights to its technology, patent protection increases the value of that technology and of the company itself.
The company can pursue research and development (R&D) and commercial development with less fear of competitors "stealing" or infringing on its technology. Most importantly, patents can attract royalties from commercial partners with the financial clout to fund R&D, clinical trials, product development and marketing.
Does the company have a track record of productive research and development? In 2019, large-cap biotech companies spent about 24% of revenue on R&D, while their small-cap counterparts spent more than five times their revenue on R&D. Not surprisingly, the outcome of R&D spending can vary wildly, especially for early-stage 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.
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.
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 product-development process can be very long and expensive. 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.
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, thus 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 solid cash 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 a company's potential.