Making a Valuation of a Biotechnology Firm

This study provides a practical analysis of company rating. I illustrate the application of equity rating by valuing a pharmaceutical company in China, Sinovac Biotech Ltd. The possible clients for the study are chiefly investing Bankss, hedge financess, company itself, rivals, single investors every bit good as authorities establishments. The purpose is to supply information to see and buy a interest in Sinovac, make up one’s minding whether there will be a high growing in the hereafter.

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After study the study, the clients would hold a clear thought about the investing potency in Sinovac. I use top-down attack, from universe economic state of affairs, biotech industry analysis to company rating, which gives the clients a comprehendible image about company ‘s strengthen and possible failing. Furthermore, the clients will obtain elaborate information about house value by comparing existent traded monetary values with intrinsic values calculated utilizing both discounted hard currency flow and existent options methods together. As research and development disbursals are an of import portion in the biotechnology industry, the DCF technique entirely is unequal to value a existent biotech company exactly. The existent options analysis will be used to capture the value of R & A ; D investings.

Table of Contentss 3

1. Introduction

Equity rating plays a utile function in portfolio direction, in amalgamations and acquisitions analysis, and in corporate finance countries. In general, there are three theoretical accounts to rating: the discounted hard currency flow ( DCF ) theoretical account, comparative rating, and existent options theoretical account. The most widely used method is DCF rating, associating the value of an plus to the present value ( PV ) of expected future hard currency flows on that plus. This attack is easiest to utilize for houses whose hard currency flows are presently positive and can be estimated with dependability for future periods. The PV of its projected free hard currency flow ( FCF ) is used to deduce the value of a company, which is based on a assortment of premises and judgements.

It is normally acceptable that the DCF technique is unequal to value a existent biotech company with the development of new drugs as it does non capture the flexibleness inherent in these undertakings. This flexibleness can be captured through the existent options methodological analysis. I use existent options to warrant the big sum of investings in what seems to be cashless or unprofitable under traditional DCF method but really creates compound enlargement options in the hereafter. That is to state, the existent options technique would optimally clip and distribute initial investing into a multiple-stage investing construction. At each phase, direction has an option to wait and see what happens every bit good as the option to abandon or the option to spread out into the subsequent phases.

In this undertaking, I estimate the value of a pharmaceutical company, Sinovac Biotech Ltd. , in order to compare how close my computed intrinsic monetary value to existent market monetary value and whether it is a good concern to put this mark company. Both DCF and existent options theoretical accounts will be used in the undermentioned study as the house value can be derived from the expected hard currency flows of the company ‘s bing merchandises and possible value of grapevine drugs.

The undertaking is organised as follows. First, I describe current universe state of affairs and biotechnology industry analysis briefly. After presenting a new drug development procedure, the company overview in footings of its background, merchandises and financials are analysed. And so I estimate the house value utilizing DCF and existent options ratings to obtain intrinsic monetary value per portion. Next it comes to rating of consequences by comparing the market monetary value to intrinsic monetary value. The concluding portion is the decision comment.

2. Economic Situation

In 2010, universe end product is expected to lift by approximately 4.25 % , following a 0.5 % diminution in 2009. The planetary recovery has evolved better than expected although retrieving at changing velocities, which is lukewarmly in many developed states but solidly in most rising and developing states. As can be seen from Figure 1, the planetary activity has rebounded since 2009 among universe trade, industrial production, employment, and retail gross revenues. Employment continues to contract in advanced economic systems but expands in emerging economic systems with a strong possible growing.

Figure 1

Beginning: IMF staff estimations

It is deserving observing that universe existent GDP growing of 3.25 % on an annualized footing picked up get downing in the 2nd one-fourth of 2009 and rose to over 4.5 % in 2010. However, end product in most parts remains below or around precrisis degrees excepting emerging Asia, which accounts for a turning portion of universe activity as indicated in Figure 2. In China, GDP growing exceeded the authorities ‘s 8 % mark in 2009 and is expected to lift to 10 % in both 2010 and 2011 chiefly built on a publically goaded growing way and substructure investing.

Figure GDP Growth

Beginning: IMF staff estimations

Sluggish existent activity and trade good monetary values have dampened rising prices force per unit areas in which illustrated in Figure 3. In the advanced economic systems, headline rising prices is expected to worsen from 3.5 % in 2008 to a record low 0.25 % in 2009, lifting up to 0.75 % in 2010. Indeed, low or even negative consumer monetary value is expected to see in some states. In the development economic systems, rising prices has been higher and more volatile, which is forecasted to lessen to 5.75 % in 2009 and 5 % in 2010, down from 9.5 % in 2008.

Figure CPI Inflation

Beginning: IMF staff estimations

In decision, planetary growing is forecast to retrieve in all parts with 4.25 % in 2010 but still remain below precrisis degrees during the average term. Furthermore, planetary economic system in developed states is projected to turn a faster velocity than that of in emerging states. Harmonizing to IMF appraisal, advanced economic systems are expected to spread out by 2.25 % and 2.5 % in twelvemonth 2010 and 2011, severally, following a diminution in end product of more than 3 % in 2009. While emerging economic systems are projected to turn about 6.25 % during 2010-2011, following a modest 2.5 % in 2009.

3. Industry Analysis

Harmonizing to Datamonitor study, the Chinese biotechnology market generated entire grosss of $ 6.3 billion in 2008, stand foring a compound one-year growing rate ( CAGR ) of 18.1 % for the period crossing 2004-2008. In comparing, the US and Nipponese markets reached entire values of $ 91.9 billion and $ 18.6 billion in 2008, with CAGRs of 12.7 % and 7.5 % , severally. However, the pharmaceutical industry in China is still small-scale because of a lower market concentration and higher international trading fight. Furthermore, the medical/healthcare proved the most moneymaking section for the Chinese biotechnology market in 2008, bring forthing entire grosss of $ 5.8 billion, which is tantamount to 91.5 % of the market ‘s overall value. By 2010, the Chinese biotech market is projected to make $ 9 billion.


4. Company Analysis

4.1 New Drug Development

Before presenting the company overview, it is necessary to depict the development of a new drug briefly as it is a complicated and hazardous concern. Drug companies must take carefully the compounds that may hold pharmacological consequence as the 1000000s of dollars invest in development costs required in order to establish a new merchandise on the market. In China, the State Food and Drug Administration ( SFDA ) regulates and supervises biopharmaceutical merchandises under the relevant Torahs in general. There are several phases about R & A ; D procedure, every measure of its biopharmaceutical production is capable to the demands on the industry and sale of merchandises as provided by these Torahs and ordinances, the vaccinum merchandises are non officially approved for sale in the market until both the merchandise itself and the production of the merchandise have been approved.

The full R & A ; D procedure typically passes through the undermentioned process:

Preclinical trials include in-vitro laboratory rating of the merchandise campaigner every bit good as in-vivo carnal surveies to measure the possible safety and efficaciousness of the merchandise campaigner. An investigational new drug application ( IND ) must be approved before come ining human clinical tests.

In Phase I, the initial debut of the drug into human topics, the drug is normally tested for safety, dose tolerance, and pharmacologic action in a little figure of independent voluntaries. Phase II normally involves surveies in a limited vaccinum population to measure preliminarily the efficaciousness of the drug for specific, targeted conditions, to find dose tolerance and appropriate dose, and to place possible inauspicious effects and safety hazards. Phase III tests further evaluate clinical grounds of efficaciousness and trial for safety within an expanded vaccinum population. This concluding pre-marketing clinical development stage is designed to closely come close the mode in which the drug will be utilized after marketing blessing.

After successful completion, a new drug application is submitted to the SFDA for to be finally admitted for market launch of the merchandise campaigner.

4.2 Company Overview

Sinovac Biotech Ltd. is a profitable biopharmaceutical company headquartered in Beijing, China. In Sep. 2003, Sinovac was listed on Nasdaq OTCBB. The Company focuses on the research, development, industry and commercialisation of vaccinums that protect against human infective diseases including hepatitis A, seasonal grippe, H5N1 ( bird grippe ) pandemic grippe and H1N1 grippe. In 2002, Sinovac launched its first merchandise, Healive, which was the first inactivated hepatitis vaccinum developed, produced and marketed by a China-based maker. In 2005, Sinovac received regulative blessings in China for the production of Bilive, a combined hepatitis A and B vaccinum, and Anflu, a split viron influenza vaccinum. Sinovac received blessing in 2009 for its H1N1 grippe vaccinum, PANFLU.1 and has commenced carry throughing orders from the Chinese Cardinal Government chase to the authorities carrying plan, which was the first company worldwide to have blessing for H1N1 influenza vaccinum. Sinovac has a robust grapevine of new vaccinum merchandises under development. The company is presently developing vaccinums for Enterovirus 71 ( EV71 ) , Pneumococcal Conjugate Vaccine, Hib, and Meningitis.

Below is a tabular array that outlines company current marketed merchandises and those that have developed or are developing.

Table Merchandises Phase

Both the fiscal high spots for past five old ages and fiscal ratios consist of multiples, purchase, profitableness and borders in Sinovac Biotech Ltd. with its chief rivals are illustrated in Table 2. It can be seen that the grosss had the mean growing rate of 80 % for past five old ages. Indeed, the higher profitableness ratios and borders of Sinovac than other rivals measure the efficiency and powerful return. The low purchase ratios show Sinovac has the ability to run into its short-run duties. Therefore I expect that Sinovac would hold a high growing potency in the close hereafter.

Table Key Financials

The value of a company is written as:

Company Value = Present Value of Free Cash Flow from Existing Merchandises ( utilizing DCF theoretical account ) + Value of R & A ; D Investments ( utilizing existent options analysis )

4.3 Discounted Cash Flow Valuation

4.3.1 Project Free Cash Flow

The projected FCF is critical on rating in a DCF, which is driven by premises underlying its future fiscal public presentation, including gross revenues growing rates, net income borders, depreciation & A ; amortisation, capex, and working capitals. Typically, the FCF is projected for a period of five old ages in a DCF, but Sinovac is still in the development phase and the net income has become positive since 2007. Hence, I use 10-year projection period to let the company to make a steady degree of hard currency flow.

The free hard currency flow computation is exhibited as:

Historical public presentation provides valuable penetration and tendency for developing defendable premises to project FCF. It is true that past growing rate, net income borders, and other ratios are normally a dependable index for future public presentation. Therefore I used the anterior four-year period as a good placeholder for calculating future fiscal public presentation. In add-on, three instance scenarios ( base, upside and downside instances ) were considered in order to back up and support these premises. See the Appendix 8.1 and matching Excel Spreadsheet.

4.3.2 Leaden Average Cost of Capital ( WACC )

WACC is a loosely recognized criterion for usage as the price reduction rate to cipher the PV of a company ‘s projected FCF and terminal value. The expression for the computation of WACC is shown as follows:

Cost of Equity

In order to cipher cost of equity, I use CAPM theoretical account which is normally used in uncovering the risk-return relationship. Note that Sinovac Biotech Ltd is a China-based company which listed in the US, therefore both the hazard free rate and market return are based on US market to maintain the consistent with the market monetary value.

First I decided to utilize a 3 month US Treasury Bill for the computation of the hazard free rate, which is a more accurate appraisal based on short term involvement rates in the US. I took monthly outputs of the 3 month T-Bill from 01/01/2005 to 31/12/2009 from DataStream, as I believe this gives a good appraisal across the concern rhythm and hence the tendency of hazard outlooks of the market for the hereafter. The geometric norm of T-bill outputs ( 2.74 % ) is used, which is a better step for past public presentation and for how investors think over long term periods.

Beta measures the sensitiveness of single plus to market portfolio, which is the covariance between the rate of return on a company ‘s stock and the overall market return, with the S & A ; P 500 traditionally used as a placeholder for the market. The Bloomberg gave the adjusted Beta of 1.22 for Sinovac over the past 5 old ages, demoing the relation of Sinovac Biotech ‘s returns with that of the S & A ; P 500 index.

Following, I estimated the geometric norm for the S & A ; P 500 as the market return over the same dataset, and so proceeded to take away the corresponding hazard free rate in order to cipher the market premium. The historical geometric norm of market return is 11.4 % , geting at a market premium of 8.66 % .

Therefore, the cost of equity for Sinovac Biotech by utilizing the standard CAPM model is 13.3 % .

Cost of Debt

Although Sinovac Biotech Ltd is non in the recognition evaluation list, the company default spread can be estimated from the involvement coverage ratio in its simplest signifier. The involvement coverage ratio is calculated as follow:

Table 3 Interest Coverage Ratio

I compared the involvement coverage ratio for the past 5 old ages and so took the norm of 24, which is within the AAA bracket with default spread of 0.35 % . Furthermore, Sinovac is a China-based company, all vaccinums developed and marketed are chiefly focus on China, therefore the state spread of 1.35 % should be considered.

Pre-tax Cost of Debt = Risk-free Rate + Company Default Spread + Country Default Spread

= 2.74 % + 0.35 % + 1.35 % = 4.44 %

Taking into history the PRC income revenue enhancement rate at 25 % from company one-year study, I obtained the after revenue enhancement cost of debt of 3.33 % .

Capital Structure

It is necessary to analyze the capital construction of the house in order to happen the weighting of debt and equity. I did this by utilizing a clip series analysis of Sinovac ‘s purchase ratios over the past 5 old ages, in footings of both debt to capital and debt to equity, the tendencies of which are illustrated in Figure 5 below.

Figure Leverage Ratio

The graph shows that Sinovac seems to be really favorable with low degree of purchase. Taking norm of Debt/Equity for the past five old ages, I obtained the entire debt to entire capital of 18.8 % and entire equity to entire capital of 81.2 % , severally.

Given above cardinal inputs, the WACC of 11.3 % can be calculated.

4.3.3 Determine Present Value of FCF

The company ‘s terminal value can be estimated by utilizing sempiternity growing method below:

Where g is sustainable growing rate of 5 % in the implicit in premise.

In a DCF, the present value computation is performed by multiplying the projected FCF for each twelvemonth and the terminal value by its several price reduction factor. Then the entire PV of FCF of $ 172.23 million for base instance is obtained by summing the present values in the projection period.

4.4 Real Options Evaluation

4.4.1 Patents as call options

A merchandise patent provides the house with the right to develop the merchandise and market it. As we know that the house will develop a patent merely if the present value of expected cashflows from the merchandise gross revenues exceeds the cost of development. If this does non happen, the house would postpone the patent and no farther cost incurs. Assume S is the PV of expected hard currency flows and K is the PV of the costs of commercially developing the patent, so:

The final payment from having a merchandise patent = S – K if S & gt ; K

= 0 if S & lt ; =K

Therefore, this final payment is indistinguishable to the final payment on a call option on the implicit in plus, the value of merchandise patent.

4.4.2 Black-Scholes Model

The most popular option rating technique is Black-Scholes ( B/S ) theoretical account. It is a closed-form, neat, and individual equation expression that computes the monetary value of a call option for a risk-neutral investors. Since Sinovac has n’t declared any dividends yet ; the B/S theoretical account for a European call option is given by:

Where N ( . ) denotes the criterion normal cumulative distribution map

For Sinovac Biotech Ltd. , the research and development costs of the drugs since 2003 are summed together to be $ 14.048 million, where is the K in our instance. Additionally, the gross revenues of company will turn at 30 % based on R & A ; D disbursals in the close hereafter, giving S of $ 18.26 million. For involvement rate, I took the geometric norm of long-run Treasury Bonds rate ( 10 old ages ) of 4.3 % . The patent normally has a period of 20 old ages ( T ) . And Bloomberg estimates the industry norm volatility ( I? ) in house value for publically traded biotechnology houses is 44.94 % .

Based on these premises, I obtained the undermentioned inputs to the option pricing theoretical account.

Table 4 Black/Scholes Model

Therefore, the value of R & A ; D investings utilizing existent options technique is $ 13.27 million.

5. Evaluation of Consequences

It is necessary to execute a sensitiveness analysis to bring forth a rating scope as the DCF incorporates legion premises about cardinal public presentation drivers. See downside and upside instances, the corresponding spreadsheet displays the PV of FCF scope from $ 50.19 million to $ 328.26 million.

Summarizing up to both DCF and existent options methods, the entire endeavor value for base instance is $ 185.5 million. Meanwhile, that value ranges from about $ 63.5 million to $ 341.5 million for downside and upside instances.

To deduce equity value, the company ‘s debt outstanding of $ 17.7 million is subtracted from the deliberate entire endeavor value. The monetary value per portion of $ 3.94, $ 1.07 and $ 7.6 are obtained for base instance, downside instance and upside instance, severally.

Comparing to market traded monetary value per portion of $ 3.96 at 23 August 2010, it can be seen that the deliberate portion monetary value remains close to market monetary value. Figure 6 shows the current market monetary value motions of Sinovac Biotech, which ranges between $ 1.04 and $ 10.5 per portion. Therefore, the rating methods in this study give the clients a sound and dependable appraisal about implicit in premises and house value for Sinovac.

Figure 6 Stock Price of Sinovac Biotech

6. Decision

In this study, I took measure by measure process to company rating by utilizing both DCF and existent options theoretical accounts based on a figure of different premises to cipher the house value every bit outlined in old rating portion. It is true that the existent options approach provides a powerful model to do endeavor value more precise with the market value. Indeed, option pricing theory addendums discounted hard currency flow rating by sing managerial flexibleness, which is normally neglected by the traditional methods.

The consequences of my theoretical account indicate that the scope of monetary value per portion of Sinovac Biotech under different scenarios estimated through the procedure truly fits the current market monetary value really good. More significantly, there may be a positive signal to derive favorable returns for investors in the hereafter based on company financials and values.

7. Mentions

Benninga, S. ( 2002 ) . “ Real options: an debut and an application to R & A ; D Valuation. ” The Engineering economic expert, Vol 47, No 2, pp151.

Damodaran, A, 2002, Investment Valuation, 2nd Edition, Wiley, NY.

Hartmann, M. and A. Hassan ( 2006 ) . “ Application of existent options analysis for pharmaceutical R & A ; D undertaking rating — Empirical consequences from a study. ” Research Policy, Vol 35, No3, pp343-354.

J. Rosenbaum & A ; J. Pearl, Investment Banking: Evaluation, Leveraged Buyouts, and Mergers & A ; Acquisitions, Wiley.

Kellogg, D and Charnes, J M ( 2000 ) . “ Real Options Evaluation for a Biotechnology Company, ” Fiscal Analysts Journal, May-June, pp 76-84.

Myers, S. C. , and C. D. Howe, “ A Life-Cycle Financial Model of Pharmaceutical R & A ; D, ” Program on the Pharmaceutical Industry, MIT ( 1997 ) .

Mum Johnathan, “ Real Options Analysis versus Traditional DCF Valuation in Layman ‘s Footings ” , Rea Options Valuation.

Olena, B and Janos, P ( 2001 ) , “ Real Option Approach to R & A ; D Project Valuation: Case Study at Serono International S.A. ” , the Financier, Vol 8, No 1-4.

Perliz, M ; Peske, T and Schrank, R ( 1999 ) . “ Real Options Evaluation: The New Frontier in R & A ; D Project Evaluation? ” R & A ; D Management, Vol 29, No 3, pp255-269.

Schwartz, E. S. ( 2004 ) . “ Patents and R & A ; D as Real Options. ” Economic Notes, Vol 33, No 1, pp23-54.

Trigeorgis, L. , “ Real Options, Managerial Flexibility and Strategy in Resource Allocaton ” , The MIT Press, Cambridge, Massachusetts, 1997.

Villiger, R. ( 2005 ) . “ Geting existent about ratings in biotech. ” Nature biotechnology Vol 23, No 4, pp423-428.




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