I’ve decided to make the effort to design a relatively simple study to determine the change in valuations of the biotech and pharma industries over the past two years. I find this type of analysis useful in my profession by comparing the changes in the major biotech indices and the aggregate market cap of the companies comprising the indices over a specified period of time. In this study, I’ve chosen the Nasdaq Biotech Index (NBI), the AMEX Biotech Index (BTK) and the AMEX Pharmaceutical Index (DRG). In another post I will explain the results of my study and why I’ve also included the results of the DRG index in this study.

Keep in mind that Biotech Informer focuses on small cap biotechs which have yet to achieve profitability. Therefore, traditional valuation metrics such as P/E and PEG ratios don’t apply. Instead, the fundamental component we use to develop a valuation metric will be “technology value”. Tech value is an appropriate component of a company’s valuation as it represents what the market is willing to pay for a company’s pipeline of products. With small cap biotechs, the drug pipeline is the basis for making an investment in the company as it is the drugs that will create value (or destroy) for the company.

Although tech value IMO is the most important component in the valuation assessment, there are other factors to consider when valuing a specific company. Similarly, when valuing profitable biotechs, we wouldn’t want to use only the simplistic P/E and PEG ratios. However, when taken in aggregate across large numbers of companies (as we will see with the companies comprising the NBI and BTK), our metric of “tech value” provides insightful information as to how the industry is valued during a specified period of time.

So how do we define tech value?

Technology value as I define it, is market capitalization minus net cash. I prefer to focus on net cash when conducting analysis on balance sheets as this is the most important variable when determining the financial strength of the company. Therefore long term debt must be subtracted from cash. To determine how critical the long term debt figure is, I generally don’t subtract from cash any convertible bond debt if the maturity date is more than five years in the future. Why? because so many other events could occur before that date that might give me reason to change my view on the company’s technology such as clinical trial failure or competitive threats. Conversely, good trial results on drugs for unmet medical indications in large markets could mitigate convertible debt financial obligations.

Tech value therefore is the aggregate value of a company’s non-cash assets such as it’s pipeline of drugs and intellectual property. Because these assets are difficult to value, tech value fluctuates dramatically with changes in market sentiment towards biotech stocks. It is for this reason that tech value makes for an ideal variable for the development of a relative valuation metric.

Tech value fluctuates rapidly between different periods of market sentiment. During optimistic periods, news from a phase 1 drug can cause dramatic rises in pipeline value while in highly negative environments even positive news on a phase 3 drug may not be awarded much value. So, the magnitude of tech value is dependent upon what investors are willing to pay for pipeline of drugs at different points in time and this is why it’s a useful tool to know the history of tech values over time.

An interesting point to make is that net cash is not nearly as important a component of market capitalization as tech value (at least in my findings). Tech value is always a larger component and it is only during extremely negative market sentiment where tech value and net cash approach equivalence.

Now that I’ve discussed a bit on the methodology used in valuing small cap biotechs, I will address the results of my study on the biotech indices and the industry’s aggregate market cap in the next post.