MANUAL Objetivo:

The value that investors ascribe to pharmaceutical companies and the indus- try as a whole is based on perceived innovative power to a significant extent. With the exception of smaller, frequently off-patent “tail” products and ancil- lary activities, most revenue streams are finite. In fact, the largest revenue and profit streams usually face rapid erosion upon the expiration of patents or regulatory exclusivities, with an inherent risk of diseconomies of scale unless they can be replaced through portfolio rejuvenation or the company substan- tially reduces its fixed costs in the wake of a pronounced top-line decline. Until the middle of the last decade, one-year-forward P/E multiples in the mid- to high teens reflected the market’s expectation that the industry would be able to innovate so as to maintain the historical double-digit growth rates indefinitely. With patent expirations looming and following numerous clinical setbacks that had left pipelines depleted, many of the majors traded on single-digit or low- double-digit one-year-forward P/E multiples in 2008 because the attractive cash flows that the industry continued to generate were widely expected to come to an end in the near future.

The structural issues described earlier decrease the utility of many of the standard approaches to valuation that are used routinely in other industries. Peer group analyses are complicated by the heterogeneity of the industry: The marked differences in patent exposure, competitive threats, and pipeline matu- rity and depth translate into pronounced differences in the predicted growth trajectory and risk–reward profile of individual players. Furthermore, there are relatively few “pure plays” whose exposure is limited to branded prescrip- tion drugs for human use; many of the industry leaders are engaged in miscel- laneous ancillary activities, including OTC drugs, diagnostics, generics, and products for animal health. Some of the midsize players even have exposure to the fields of chemicals and agriculture, which may merit different sales and profit multiples.

Owing to the substantial differences in margins and margin structure that arise principally from the manner in which drug profits are shared between companies and recognized in their financial statements, enterprise value (EV)/ sales ratios are rarely used in the valuation of pharmaceutical companies. All things being equal, a company that books substantially all of the sales of the products for which it has marketing rights but pays high royalties to the

originators of those drugs does not merit the same EV/sales multiple as a com- pany that owns 100% of its assets. Also, care should be taken in the case of companies that receive substantial drug-related profits that they book through the “other revenues” or “other operating income” line. Substantial differences in profitability that may render the EV/sales multiple meaningless also arise below the earnings before interest and taxes (EBIT) line, as in the case of stakes in other companies and also tax rates, which can vary dramatically between companies and fluctuate over time.

EV/EBIT multiples account for differences in margin structure but may be distorted by high levels of amortization in the case of companies that have made major acquisitions. EV/EBITDA (earnings before interest, taxes, depre- ciation, and amortization) may be a more suitable measure because it reflects all aspects of current operating performance, with the caveat that the selec- tion of a “fair” discount or premium of a company relative to its peer group requires a judgment call on the company’s future growth and risk profile rela- tive to its peer group, in addition to a view on such “below the line” items as taxes. There is no standard approach to deriving the premium or discount a stock merits; relative valuations reflect both the perceived longevity of current cash flows and the shareholders’ faith in a company’s pipeline and innovative power in general.

P/E multiples are generally the most popular metric used to assess relative valuation, and stocks often revert to historical average premiums or discounts unless a company’s fundamentals have improved or deteriorated markedly relative to its peer group. Like EV/EBITDA, P/E multiples reflect the market’s view of a company’s current profitability and future fundamental prospects, with the added advantage of incorporating such nonoperating items as taxes and income from associates. Financial leverage tends to be relatively low in the pharmaceutical industry and is unlikely to distort P/E ratios significantly. A word of caution: There are slight differences between companies’ adjusted EPS figures, and not every company provides an adjusted EPS figure. Brokers who contribute to consensus forecasts may overlay their own standards for adjusting and harmonizing EPS figures. Thus, care must be taken to ensure that P/E multiples are calculated on the basis of, or applied to, comparable EPS figures.

Cash-flow-based valuation approaches sidestep the issues arising from the lack of comparability between pharmaceutical companies that hamper peer group analyses. Such approaches capture the medium-term profit outlook with a relatively high degree of reliability because the visibility on peak sales and patent loss of key profit drivers is fairly high. Inevitably, they require a judg- ment call on the quality of a company’s pipeline and its ability to innovate. By

Financial Statement Analysis

their very nature, methodologies based on discounted cash flow (DCF) tend to be highly sensitive to assumptions about the terminal growth rate, which include implicit assumptions about the long-term growth of cash flows from ancillary activities as well as the ability of the company’s branded prescription drug business to continually reinvent itself following patent expirations. In conclusion, DCF-based valuation approaches may yield the best approximation to “fair” value, provided that investors and analysts have a high level of confi- dence in the company-specific forecasts that serve as inputs.

Reverse-DCF analyses that gauge the terminal growth rate implied in a stock’s current share price reveal the market’s view of a company’s long-term innovative capacity. Investors may consider the likelihood that a company will meet or exceed market expectations in the long term as well as the plausibility of differences in long-term growth prospects priced into the shares of pharma- ceutical companies.

Owing to drug firms’ relatively high dependence on individual drugs and the operating leverage associated with large assets, project-specific NPV mod- els are popular with analysts and investors. It is important, however, to be aware of their limitations, especially concerning the uncertainty of forecasting drugs—at an early stage of development, a drug’s peak sales potential and its effective period of exclusivity may be very difficult to predict—and the inherent challenge of allocating the substantial fixed costs that continue to characterize drug firms even in this era of in-licensing and outsourcing to individual proj- ects. Bottom-up valuation approaches that consist of adding up project NPVs may constitute a viable approach for biotechnology firms with limited infra- structure and few drugs in development. However, in the case of large phar- maceutical companies that rely on the continued success of marketed products as well as permanent rejuvenation of their portfolios in order to maintain their existing infrastructure, NPV models are better suited to sensitivity analyses. For example, NPV models of potential blockbuster drug candidates or key mar- keted products that take into account only the variable cost associated with these assets may provide a rough idea of the implications of clinical success or failure—or of the potential withdrawal of a product from the market owing to safety issues—for a stock’s valuation and the business decisions a company might be forced to make in the event of failure. Table 4 reports on the suitabil- ity of various valuation methodologies for the industry.

Table 4. Suitability of Standard Valuation Methodologies for the Pharmaceutical Industry

Method Suitability Commentary

EV/sales Low This multiple does not adequately capture differences in margins that may arise as a result of drug profit sharing between companies.

EV/EBITDA Medium This multiple does not capture substantial differences “below the line” (e.g., relating to associate income and variations in tax rates).

P/E High This is the most widely used multiple; because individual companies’ prospects may differ materially, it requires the user to consider the premium or discount merited by a stock relative to its peer group. DCF High This approach captures the analyst’s specific

views on a company’s prospects and thus sidesteps issues that may arise from the industry’s heterogeneity and resulting lack of comparability across peer groups. Reverse-DCF High This methodology gauges the terminal

growth rate implied in a stock’s current share price and thus reveals the market’s view of a company’s long-term innovative capacity.

NPV models Medium The use of drug- or project-specific NPV models should be reserved for sensitivity analyses. This approach does not lend itself to bottom-up valuation, owing to the dif- ficulties of allocating fixed costs to a large number of individual projects.