Valuation of pharmaceutical firms using real options: A CCS study on valuation methods

Abstract

In this study, we study the typical drug development process of a pharmaceutical firm and use this knowledge to value the firm. Valuing such a firm would require us to consider the typical uncertainty and the abandonment options that the project managers of these firms have. We have explored some existing approaches for real option valuation and tried to extend the same to pharmaceutical firms. We have also evolved a Monte Carlo simulation method which would act as a simulation bed to help us value the firm. We conclude by pointing out some future directions which this research could take. The study encompasses a thorough analysis of the valuation process of pharmaceutical companies. The value of a pharmaceutical company can be derived from 3 sources. (a) Real Assets: These are mainly the fixed assets of the company like land, building, human capital and any other resources needed as a pharmaceutical company. (b) Generic Drugs: These are drugs, which are produced and distributed without patent protection. It may have a patent on the formulation but not on the active ingredient. The principal reason for the relatively low price of generic medicines is that competition increases among producers. Also, there is no drug discovery cost incurred instead the engineers are able to reverse-engineer known drug compounds to allow them to manufacture bioequivalent versions. After the patent on a drug expires, any pharmaceutical company can manufacture and sell that drug. Many companies are able to make profits by manufacturing and selling these generic drugs. (c) Drug development: It refers to activities undertaken after a compound is identified as a potential drug in order to establish its suitability as a medication. Objectives of drug development are to determine appropriate formulation and dosing, as well as to establish safety. The focus of this study would be limited to the value of the pharmaceutical company contributed by the development of new drugs. The whole drug development process is a highly regulated sequential research stage that covers the biological validation of the drug target and the subsequent chemical optimization of the potential drug candidates. The pre-clinical phase mainly comprises of animal testing.