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Accounting for risk in pre-clinical companies?

  1. Tasnat

    323 Posts.

    I recently read the BBY company research paper (November 2014) which is available on NRT website (as I'm sure most of you know).

    I have no criticism of the work, it was very interesting, but did raise some questions for me around how risk is applied when valuing pre-clinical trial companies. The report states that the average success rate for small molecule phase 1 trials is 13%, and then applies 12% and 8% (weighted average works out at approx. 9%) predicted success rates for the various pipeline products because there is still some preclinical work to achieve (which sounds fair enough). Those percentages are then multiplied by the estimated royalties to be received if the NRT products meet a predicted market penetration % and arrive at risk adjusted revenue forecast. The report goes into more detail than I will here, but basically it arrives at an NPV (with discount rate of 15%/year) for the projected risk adjusted cashflows out to the year 2030ish (arriving at a price of about $0.22).

    As an alternative I did a point in time valuation from the estimated revenue in the report (10 years hence) except without adjusting for risk of failure, and added a PE multiplier because im not using a long series of cash flows.

    Assumptions made:
    - Total shares on issue (taking into account future fund raising) at 500 million.
    - Time to market is 10 years
    - All four products are at market in 10 years
    - Sales of licensed products in year 10 will be $3.37 billion (as adopted by BBY company research prior to risk adjustment calculation)
    - Royalty received on sales is 15% (same as adopted in BBY company research)
    -Revenue $478,612,500 (after payment to Yale)
    -Dilution will be at or approx. market value of shares (ie. not at a massive discount).

    From the above follows:
    -EPS of approx. $0.96
    - PE ratio a conservative 10
    - share price in year 10 is $9.57
    -NPV at 15% discount per year is $2.37 (unadjusted for risk)

    In other words, if someone had absolutely no doubt that all treatments would work/FDA will approve/sales will be met, and a 15% return per year is just as good as your next best option, then $2.37 would be a satisfactory price to pay today (all else being correct).

    I'm pretty confident in this company, but not 100% certain, so the below table sets out the implied confidence at given share prices (should the above assumptions be ballpark of course).

    The 9 per cent confidence level is about the same as the $0.22 price range given in the report, and is showing that the current 12 cent price shows confidence at just 5 per cent, which is way too low imho.

    Not sure what level of confidence we should have, but 1 would have thought 13 would be fair given the strong pre-clinic results to date. Not advice just my thoughts.

    The MC column wont match current actual because we don't have 500m shares on issue currently.


    Column 1 Column 2 Column 3 Column 4
    0 500m Shares on Issue
    1        
    2 % Success Implied Price Market Cap Required
    3 Confidence[/B] per Share 500m SOI Return on Risk
    4   0.00   N/A
    5 1 0.02 11,830,569 9900%
    6 2 0.05 23,661,138 4900%
    7 3 0.07 35,491,707 3233%
    8 4 0.09 47,322,276 2400%
    9 5 0.12 59,152,845 1900%
    10 6 0.14 70,983,414 1567%
    11 7 0.17 82,813,983 1329%
    12 8 0.19 94,644,552 1150%
    13 9 0.21 106,475,121 1011%
    14 10 0.24 118,305,690 900%
    15 11 0.26 130,136,259 809%
    16 12 0.28 141,966,828 733%
    17 13 0.31 153,797,397 669%
    18 14 0.33 165,627,966 614%
    19 15 0.35 177,458,535 567%
    20 20 0.47 236,611,380 400%
    21 25 0.59 295,764,225 300%
    22 30 0.71 354,917,070 233%
    23 35 0.83 414,069,916 186%
    24 40 0.95 473,222,761 150%
    25 45 1.06 532,375,606 122%
    26 50 1.18 591,528,451 100%
    27 55 1.30 650,681,296 82%
    28 60 1.42 709,834,141 67%
    29 65 1.54 768,986,986 54%
    30 70 1.66 828,139,831 43%
    31 75 1.77 887,292,676 33%
    32 80 1.89 946,445,521 25%
    33 85 2.01 1,005,598,366 18%
    34 90 2.13 1,064,751,211 11%
    35 95 2.25 1,123,904,057 5%
    36 100 2.37 1,183,056,902 0%

    Just my back of the envelope thoughts, may be of some interest and or humour - definitely not guidance/advice etc.

    BIBO warning: my assumptions could be all wrong too - wouldn't be the first time:eek:

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