Valuation and other biotech mysteries – Part 25: Undervalued compared to its peers?
[Ed. This is the twenty-fourth part in Wayne's series. You can access the whole thing by clicking here.
As with all commentary on this blog, these comments do not consider the investment objectives, financial situation or particular needs of any particular person, and investors should obtain professional advice based on their own individual circumstances before making any investment decision.]
Analyst reports will usually verbally describe a stock as fairly valued, under-valued or over-valued. For profitable companies, this verbal description is usually based on a comparative numerical analysis where the company valuation based on share price is compared to an analysis such as NPV. Analysts do make assumptions in this analysis but they usually start from a solid financial history and also have management’s guidance.
The situation is substantially different for a company at the clinical development stage for a new drug product. The only financial history is the cash burn and any NPV analyses have so many assumptions that the analyses are of questionable absolute value. If there is no useful NPV-based comparator, analysts and CEOs sometimes turn to the valuations of their peers for comparisons.
In early 2001, I did an analysis of the market caps of the public Canadian companies developing new drugs by phase of clinical development. I have not repeated this sector analysis recently but, while looking at peer valuations of some companies, I have noticed the following.
- The range of valuations at any phase of clinical development has become larger.
- There is almost no increase in median valuation going from Phase 1 to 2.
- Credit for Phase 3 is being almost entirely withheld until the Phase 3 data is released.
There are times when it is easy to choose comparator companies because the products are similar and they are being developed for the same medical condition. For example, Hemosol was one of a group of companies developing hemoglobin-based products as red blood cell substitutes and ConjuChem was one of a group of companies developing GLP-1 analogs as diabetes treatments. However, peer groups usually have more diversity than these two examples.
Just as an NPV analysis can be biased with aggressive assumptions, peer comparisons can be biased by the choice of the comparators.
- Companies in hot versus out-of-favor sectors
- Companies which have had a clinical hiccup versus those with a clean development history
- Companies with cash to complete current clinical programs versus those needing to complete a financing
The fact that a company may be undervalued compared to its peers may justify taking a closer look at that company. However, since the purpose of a potential investment is capital gains, the key question remains what event or series of events is going to make the share price rise.