The idea is to find a way to apply value-investing principles in this nontraditional sector. In Value Investing: From Graham to Buffett and Beyond, Bruce Greenwald provides a three-step framework for valuation. First, value the real assets on the balance sheet. Second, determine the earnings power of the company at the moment of the calculation. Third, add a provision for growth, deeply discounted.
Biotech valuation is simpler. Since most development-stage biotech firms have no revenue, much less income, valuation is only a balance-sheet exercise. Start with the IP: if the company ceased operations and locked the patents and data in a vault, how much would another biotech or pharmaceutical company pay for those assets? Add some provision for the cash on hand and derive a valuation.
There are two situations where this valuation is something other than a guess. Type one is where the enterprise value of the company is less than zero. One can evaluate whether the value of the noncash assets is more than nothing. Type two is when the market tells us what an informed buyer would pay for a similar asset.
Each Sunday night the investment bank Rodman and Renshaw publishes a report on the state of the public biotech market, including a list of those companies whose market capitalization is less than the cash on the balance sheet. The March 1 report lists 29 public companies trading below cash, 21 of which had zero debt. These less-than-cash market caps can put a zero value on still-viable assets: e.g., a legitimate drug discovery platform, a revenue stream from collaborations, or an earlier stage pipeline of product candidates.
This “is this worth more than nothing” category yields a group of companies needing further study. In this case the margin of safety derives from the educated investor’s confidence that the asset under development is legitimately worth something. Investors able to understand the underlying science and the clinical relevance and verify the quality of the clinical trial design can assess these cases in a systematic, nonspeculative manner.
Of course, no trial or regulatory decision is entirely predictable. The prudent biotech investor will choose to handicap only a small number of the ultralow or zero-value companies that he or she finds.
An example is Medicinova, a company that in-licenses drugs from Japanese companies and develops them. On March 1, the firm had a market cap to net cash ratio of 0.58 and reportedly sufficient cash to fund its clinical trials for two years. Its two lead compounds each demonstrated proof of concept and targeted large clinical indications. Unfortunately, an ill-advised road show to test the waters and maybe raise an extra year of cash coupled with the recent market downturn dropped the share price from $8 to $3.50 over the past five months, even as additional validating clinical data was reported. Clearly the Medicinova assets are worth much more than nothing.