Agenda

•Concepts

        -The relationship between value of intellectual property and value of the device or drug

        -The difference between risks and options

        -Valuation in practice 

                Typical implementation via a scenario and its limitations 

                Transparent valuation using a binomial tree to account for options and risks

•Quantitative example

        -Three stage R&D with abandonment option

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Concepts

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Concept 1: Value of IP versus value of the drug or device

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•Difference between value of the device or drug & the value of the patent, trademark or trade secrets that represent the intellectual property (IP) behind the device or drug.

•Value of the device or drug represents the present value of the expected cash flows that will flow from commercialization.

        -Total value will be allocated amongst the holder of the IP & the entity that can commercially exploit the IP.

        -The commercial entity is responsible for manufacturing, distribution &marketing &the holder of the IP is responsible for the idea &the science.

        -One entity can perform both roles –development & commercialization –but it is easiest to think of two entities with specialized roles.

•How total value of the device or drug is allocated amongst the R&D firm &the commercial firm depends upon their capabilities &market power.

        -If we have a blockbuster drug that could halve obesity rates or increase cancer survival by 10 per cent, the value allocation will shift towards the R&D firm. The importance of manufacturing efficiency & marketing capability is diminished because the drug will sell itself.

•In contrast, some devices could be thought of as better mousetraps –they are better than alternatives, but the large medical device companies have the power to determine which devices are pushed through a distribution pipeline.

•This seminar relates to the total valuation of the investment in the device or drug.

       -Is it worthwhile for an R&D firm to invest in clinical trials at a reasonably early stage?

       -How can we handle the valuation problem for a product in which there are multiple stages, the payoffs are highly uncertain but which are very large if we are ultimately successful?

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Concept 2: Risk versus options (1) –Pathways create options

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•Devices & drugs have pathways to market that differ from other consumer products, largely because of consumer risk.

        -For a risky medical device to be sold to consumers it has to receive premarket approval (PMA) by the FDA or receive clearance because it is substantially equivalent to a device that is already allowed (a “predicate device”).

        -For a drug to be sold to consumers the FDA needs to attest that it is safe and effective.

•Cars, toys & food do not need to meet the same hurdles.

•This means that we have well-defined, staged pathways for devices and drugs to reach the market. We can’t simply run a pilot program.

•Options for abandonment or change in direction generated by those pathways

        -The existence of these multi-stage pathways for development is the first plank underpinning the use of real options for valuation. As the development of a device or drug proceeds from one stage to the next, the R&D firm has the option to abandon the project or change direction in response to new information about safety, efficacy or alternative uses.

        -This means that we can think of an investment in a device or drug as an investment in a package of options to proceed to the next stage of development, & this leads to the use of the valuation technique known as real options analysis.

 

Concept 2: Risk versus options (2) –Risk lowers value, options increase value

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•Characteristics supporting real options analysis

         -Multi-stage investments.

         -High dispersion of payoffs depending upon ultimate success or failure.

         -Investment plan can be altered as new information comes to light which resolves uncertainty.

                   -This information relates to technical performance, concerns of the FDA and insurance companies, and the size of the market and the potential benefits to consumers.

                   -This characteristic is the one that makes the difference between the negative impact on value associated with risk, versus the positive impact on value associated with real options.

•There are other investments in different industries that meet these three criteria.

         -Oil exploration

         -Information technology

         -In fact, all investments can be valued using real options analysis. But the option value increases along with multiple stages, dispersion of payoffs and flexibility in decision-making

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Concept 2: Risk versus options (3) –Irreversible investment

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Concept 2: Risk versus options (4) –Investment with options

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Concept 3: Valuation in practice

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•Our fundamental valuation principle is that the value of any asset is the present value of expectedcash flows

        -Investors care about three things –the timing, magnitude & risk of expected cash flows.

        -All else equal …

              -cash sooner is better than cash later;

              -more cash is better than less cash; &

              -a lower risk payoff is better than a higher risk payoff.

•The expectation has its statistical meaning: the probability weighted average of all possible cash flows •But for practical purposes we almost always use one scenario as the proxy for the expectation (for example, produce xwidgets at yvariable cost per widget &zfixed costs)

•That works fine for projects in which there are few options to change direction. Sure, outcomes could be better or worse than projected but a well-specified scenario will be close to the expected outcome.

•But for projects with options the use of a scenario based model fails, because there are many paths the project could take &a single scenario based model cannot handle this

•It can’t be fixed by simply running more scenarios because the scenarios need to reflect the exercise of management discretion at each point in time

•Real options analysis can be implemented in two phases, with the first phase being most important. ---              -Recall that in valuation we care about the timing, magnitude & risk of expected cash flows.

       -Phase 1 is to use a binomial tree to correctly work out the timing & magnitude of expected cash flows, & convert them to present value using a risk-adjusted discount rate. This ensures that we correctly estimate the expected cash flows.

       -Phase 2 is to extend the analysis to incorporate the risk reduction that comes from embedded options.

       -The valuation performed at Phase 2 should always be higher than the valuation performed in Phase 1 &is the more accurate valuation.

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Application

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Description

 

•Representative drug R&D after 1ststage success.

•Odds of ultimate success from now are 21.6%.

•Total investment over 3 stages is $ 200 m
•Potential payoff in 5 years is $1,167 m.

•What is the R&D worth today? 

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Results preview

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Valuation steps: Overview

1. Value the project as if you were fully committed to seeing the project to completion by working backwards

        •Why work backwards? Value today depends upon what something is expected to sell for later, and a discount to reflect risk and the time value of money

        •Why consider the fully committed project?  We want a framework for comparing projects with options, and without options, to see how much extra value we get from flexibility in decision-making.

2. Value the project as if you were not fully committed to seeing the project to completion by working backwards

        •What is the valuation difference between step 1 and step 2? Higher expected cash flows. Expected cash flows are the probability weighted average cash flows from the possible outcomes. The expected cash flows increase because you re-assess the project at each stage and only exercise valuable options.

3. Account for the lower risk of a project with options by using risk-neutral probabilities

        •What are risk-neutral probabilities? A clever computational technique (which contributed to a Nobel prize) accounting for the upside potential of options but no downside. A project with options, compared to the same project without options, has higher expected cash flows and lower risk. Step 2 accounts for the cash flow increase and step 3 accounts for the risk adjustment.

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Valuation steps: Detail (1) –Valuation of R&D without options

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1.Value the project as if you were fully committed to seeing the project to completion by working backwards

a) Ask, what is the project value at the end of stage 3?

        i. Go to the final stage (FDA approval and insurance co. acceptance) and estimate payoffs for approval versus rejection

        ii. Compute the expected payoff (the weighted average of the possible payoffs)

        iii. Discount the expected payoff to the end of the stage 3 trials

        iv. Subtract the cost of seeking FDA approval and lobbying insurers

b) Ask, what is the project value at the end of stage 2?

        i. Go the end of stage 2 and estimate payoffs for success versus failure in stage 3

        ii. Compute the expected payoff from success or failure

        iii. Discount the expected payoff to the end of stage 2 trials

        iv. Subtract the cost of stage 3 clinical trials

c) Ask, what is the project value at the end of stage 1?

        i. Go the end of stage 1 (today) and estimate payoffs for success versus failure in stage 2

        ii. Compute the expected payoff from success or failure

        iii. Discount the expected payoff to today

        iv. Subtract the cost of stage 2 clinical trials

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What would be the value of the project without options? (1)

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What would be the value of the project without options? (2)

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What would be the value of the project without options? (3)

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What would be the value of the project without options? (4)

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Valuation steps: Detail (2) –Valuation of R&D with options

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2. Value the project as if you were not fully committed to seeing the project to completion by working backwards

        a) Ask, what is the project value at the end of stage 3?

                i. Go to the final stage (FDA approval and insurance co. acceptance) and estimate payoffs for approval versus rejection

                ii. Compute the expected payoff (the weighted average of the possible payoffs)

                iii. Discount the expected payoff to the end of the stage 3 trials

                iv. Subtract the cost of seeking FDA approval and lobbying insurers

                v. Ask, what is the maximum value associated with all possible options? In this case, seek FDA approval or abandon.

        b) Ask, what is the project value at the end of stage 2?

                i. Go the end of stage 2 and estimate payoffs for success versus failure in stage 3

                ii. Compute the expected payoff from success or failure

                iii. Discount the expected payoff to the end of stage 2 trials

                iv. Subtract the cost of stage 3 clinical trials

                v. Ask, what is the maximum value associated with all possible options? In this case, invest in stage 3 trials or abandon.

        c) Ask, what is the project value at the end of stage 1?

                i. Go the end of stage 1 (today) and estimate payoffs for success versus failure in stage 2

                ii. Compute the expected payoff from success or failure

                iii. Discount the expected payoff to today

                iv. Subtract the cost of stage 2 clinical trials

                v. Ask, what is the maximum value associated with all possible options? In this case, invest in stage 2 or abandon.

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What would be the value of the project with options if we do not account for risk reduction? $28 million

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Valuation steps: Detail (3) –Accounting for risk reduction

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3.Account for the lower risk of a project with options by using risk-neutral probabilities

The R&D with the abandonment option is less risky than the equivalent project with full commitment. But we used the same 12% discount rate for both projects. We should reduce the discount rate to account for lower risk, but there are two problems.

•We don’t know what the discount rate is for the lower risk project

•The risk changes throughout the tree, and so there is not one constant rate

 

Thankfully, the clever researchers Black, Scholes and Merton worked out a way to address this problem and won a Nobel prize. The answer is to use risk-neutral probabilities and discount at the risk-free rate.

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This approach does not mean we have assumed investors are risk neutral –they are still risk averse.

        a) From the analysis of the project without options, estimate risk-neutral probabilities

        b) For the project with options, repeat the analysis but use risk-neutral probabilities and discount at the risk-free rate of interest

        c) For presentation purposes, show what discount rate would give the same valuation if we use the real-world probabilities in the analysis. The difference between the risk-adjusted discount rate used in step 1 and this computation of the discount rate provides the reader with a reference point for the risk reduction associated with options.

 

What would be the value of the project with options if we account for risk reduction? $42 million

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Summary

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