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

Is this biotech company a good investment? Like with the coin flip game, the answer depends on the cost -- in this case the price of the biotech company's stock. A share price below $50 would mean the company is undervalued and therefore a good investment. If the current stock price exceeds $50, the company is overvalued.

Of course, biotech investment decisions are not nearly as simplistic as my example, mainly because the nailing down the correct probability of a drug approval and the value of that drug approval (the discounted cash flow) is a significant challenge. In reality, these numbers have to be estimated with the associated errors.

Even setting that aside, this sort of analysis highlights two critical points that biotech investors should always keep in mind. First, a company could have a very low probability of success and be undervalued. For instance, one could assume a 2 percent chance of success with a $100 DCF, which creates an expected return of $2. If the share price is under $2, then an investment has a positive expected utility (profit) even though you expect the drug to ultimately fail. In many ways, I think this is what many Biodel (BIOD) bulls argue: The odds of success for its rapid-acting, mealtime insulin are low but the stock is cheap enough to make it a good investment.

Second, a company with a high probability of success can be overvalued. For instance, one could assume a 98% chance of success with a $100 DCF, which generates a $98 expected benefit. If the price is over $98 then the company is overvalued. A good real-life example is the bear thesis on Seattle Genetics (SGEN - Get Report): The Adcetris label will be expanded but the company's current valuation more than takes that into account.

I've simplified discussion of how expected utility theory plays a role in biotech investing. Clearly, the method can be made much more complicated with the introduction of more variables. The key take-home point is that not all biotech companies with a high probability of success are good investments, nor are all biotech companies with a low probability of success bad investments.

Perhaps the only truism is that holding all else constant, as the share price decreases the more undervalued a company becomes. The key there is "hold all else constant" because you need to be sure that the falling share price is not caused by changing probability of success or lower commercial opportunity.

Sobek is long Seattle Genetics.
David Sobek has been writing on biotech for a number of years through various outlets with a general focus on small cap oncology and antibiotics companies. He received his PhD in political science from Pennsylvnia State Univeristy in 2003 and a BA in international relations from The College of William and Mary in 1997.
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