This account is pending registration confirmation. Please click on the link within the confirmation email previously sent you to complete registration.
Need a new registration confirmation email? Click here
Stocks Under $10 with 50-100% upside potential - 14 days FREE!

Understanding a Coin-Flip Game Can Make You a Smarter Biotech Investor

NEW YORK (TheStreet) -- The market has been pulling back recently and biotech stocks have not been immune to the selling. Rather than focus on a single stock in this week's column, I want to write more broadly about valuation and how it relates to expected utility theory. In general, expected utility theory argues that individuals act to maximize the difference between expected benefits minus expected costs. While this seems intuitive, it highlights some interesting aspects of biotech investing.

Let me explain using an example of a simple coin-flip game in which a coin landing heads earns the player $100 while tails returns nothing. The expected benefit of the game is $50, calculated as the odds of heads times the payout of heads (0.5x$100=$50) plus the odds of tails and the payout of tails (0.5x$0=$0.) Obviously, this looks like a great game but it ignores the expected costs. If I am charging to play this game, how much would you pay?

If the game cost $20, for instance, then you should certainly play as the expected utility is $30 (expected benefits of $50 minus the expected costs of $20.) As long as the cost of the game is less than $50 the player has a positive expected utility and should play. Obviously, one could generate a number of different game structures but the basic analysis is the same.

So how does this relate to biotech investing?

When investing in a clinical stage biotech company, investors are implicitly playing an analogous game. There is a probability of success (regulatory approval), expected payouts from success (discounted cash flow), probability of failure (FDA rejections), payouts from failure (additional costs), and costs for playing the game (share price.) I'm simplifying things, of course, but it's still a good heuristic approach.

Take, for instance, a biotech company that has a 50 percent chance of drug approval and the discounted cash flow on approval is expected to be $100 per share. To keep it simple I will assume that the costs of failure (drug rejection) are $0. Given these assumptions, the expected benefit from investing in this company is $50 (0.5x$100 + 0.5x$0).

1 of 2

Select the service that is right for you!

COMPARE ALL SERVICES
Action Alerts PLUS
Try it NOW

Jim Cramer and Stephanie Link actively manage a real portfolio and reveal their money management tactics while giving advanced notice before every trade.

Product Features:
  • $2.5+ million portfolio
  • Large-cap and dividend focus
  • Intraday trade alerts from Cramer
  • Weekly roundups
TheStreet Quant Ratings
Try it NOW
Only $49.95/yr

Access the tool that DOMINATES the Russell 2000 and the S&P 500.

Product Features:
  • Buy, hold, or sell recommendations for over 4,300 stocks
  • Unlimited research reports on your favorite stocks
  • A custom stock screener
  • Upgrade/downgrade alerts
Stocks Under $10
Try it NOW

David Peltier, uncovers low dollar stocks with extraordinary upside potential that are flying under Wall Street's radar.

Product Features:
  • Model portfolio
  • Stocks trading below $10
  • Intraday trade alerts
  • Weekly roundups
Dividend Stock Advisor
Try it NOW

Jim Cramer's protege, David Peltier, identifies the best of breed dividend stocks that will pay a reliable AND significant income stream.

Product Features:
  • Diversified model portfolio of dividend stocks
  • Alerts when market news affect the portfolio
  • Bi-weekly updates with exact steps to take - BUY, HOLD, SELL
Real Money Pro
Try it NOW

All of Real Money, plus 15 more of Wall Street's sharpest minds delivering actionable trading ideas, a comprehensive look at the market, and fundamental and technical analysis.

Product Features:
  • Real Money + Doug Kass Plus 15 more Wall Street Pros
  • Intraday commentary & news
  • Ultra-actionable trading ideas
Options Profits
Try it NOW

Our options trading pros provide daily market commentary and over 100 monthly option trading ideas and strategies to help you become a well-seasoned trader.

Product Features:
  • 100+ monthly options trading ideas
  • Actionable options commentary & news
  • Real-time trading community
  • Options TV
To begin commenting right away, you can log in below using your Disqus, Facebook, Twitter, OpenID or Yahoo login credentials. Alternatively, you can post a comment as a "guest" just by entering an email address. Your use of the commenting tool is subject to multiple terms of service/use and privacy policies - see here for more details.
Submit an article to us!
DOW 16,912.11 -70.48 -0.42%
S&P 500 1,969.95 -8.96 -0.45%
NASDAQ 4,442.6980 -2.2110 -0.05%

Brokerage Partners

Rates from Bankrate.com

  • Mortgage
  • Credit Cards
  • Auto

Free Newsletters from TheStreet

My Subscriptions:

After the Bell

Before the Bell

Booyah! Newsletter

Midday Bell

TheStreet Top 10 Stories

Winners & Losers

Register for Newsletters
Top Rated Stocks Top Rated Funds Top Rated ETFs