Valuing Pharma R&D: The Catch-22 of DCF

Abstract

There are two principal methods for valuing pharmaceutical R&D projects—discounted cash flow (DCF) and real options valuation (ROV). As typically practiced, DCF valuations tend to be lower than the estimates produced by ROV techniques. Part of the difference, as many have recognized, stems from DCF s limited ability to take account of managers' real option to cut its losses when new information reveals a drug candidate's lack of profit potential. Another reason for the difference, however, is the widespread use in DCF valuations of established success rates that do not distinguish between projects that fail to pass safety or efficacy trials and those that are abandoned for lack of economic viability. If the appropriate success rates are used, the two methods should yield identical project values because they assume the same scenarios. The practical reality, however, is that the two methods deal in a completely different way with the possibility of abandonment for economic reasons. Because ROV accounts for this possibility directly in the model itself, it is much better suited than DCF to this task—indeed, that is the uncertainty that it is designed to deal with. And the fact that 30% of all pharma R&D abandonments are for economic reasons is a strong argument for using ROV rather than DCF to evaluate new drug development.