Trying to value biotech stocks, particularly those with no products on the market, isn't easy.

Consider, for example, that in this sector, in order to achieve an earnings multiple on which to base buy and sell recommendations, forecasting models often need to be extended out four or five years.

Imagine attempting to engage in the same exercise with retailers, like Costco ( COST), or tech companies, like Dell. Predicting what sales and earnings will be for this fiscal year is difficult enough without having to start worrying about 2010 or 2011.

Now add variables such as safety issues, efficacy, competition and the small matter of not knowing if a drug will even be approved and make it to market, and you can see how difficult it is to determine the proper valuation for a biotech stock, particularly one with no current earnings.

Nevertheless, investors love the sector because of the potential rewards. Those who bought Amylin Pharmaceuticals ( AMLN) in June of last year have already tripled their money as diabetes drug Byetta fueled enthusiasm for the stock, and long-term holders of companies like Genentech ( DNA) have indeed been nicely rewarded.

How It's Done

If you want to do your own research, the skills and time required are substantial. Simply knowing about a particular drug that will meet an unsatisfied need is not enough. For our purposes, we'll assume the company we're examining doesn't have a product on the market yet.

The first thing that's required is a peak sales estimate of every drug in the pipeline. In order to arrive at a number, you need to figure out what the patient population is for every indication that the drug will treat, what percentage of that population will use the new therapy, pricing parameters and whether it will be sold in partnership with another company. If so, then a royalty percentage estimate is needed as well.

Next, you have to estimate the costs to determine how much the drug will earn over its lifetime. Then you must assign a discount based on the probability that it will be approved. According to Dr. Joseph DiMasi, director of economic analysis at the Tufts Center for the Study of Drug Development, 69% of phase III drugs receive approval. However, only 44% of phase II drugs make it to phase III.

Rajiv Kaul, portfolio manager of the ( FBIOX) Fidelity Select Biotechnology fund, says, "The probability of success is key. You can discount all you want. If a drug is not approved and the stock is going to zero, it's going to zero."

Once you've arrived at an earnings estimate, you then need to decide what kind of multiple is attractive or unattractive. Of course, as Biren Amin, an analyst with Stanford Financial Group, cautions, "Your assumptions are based on the current market, but conditions change."

For example, you might determine that a stock with a price-to-earnings multiple of 25 and a price-to-earnings-to-growth ratio of 1.5 (based on 2010 earnings) is a buy, but four years from now those numbers could be considered expensive depending on the market environment at that time.

Risk and Reward

With so many variables to keep track of, are you better off using the Wall Street consensus? Not according to Amin.

"It's not the best avenue in some cases," he says. As a recent example, he offers the story of Nitromed ( NTMD) from last year. Analysts believed the company's BiDil, a drug approved for treating congestive heart failure in African-Americans, would generate hundreds of millions of dollars in sales in 2008. Amin says it now appears the drug won't do anything over $25 million to $30 million in peak sales.

What, then, should investors do if they have neither the time nor the resources to compute every scenario for a company's pipeline? "The Amgens ( AMGN) or Genentechs of the world, companies that actually make money, are what individual investors should be focusing on," says Amin.

There's always the option of going for the diversity of mutual funds, but often, fundholders are already participating in the larger biotech names, as I outlined last month .

The biotech sector is rife with risk for investors who blindly follow the consensus, especially on some of the small- and mid-cap names. Still, for those with a little bit of industry knowledge or who are willing to do their homework, the rewards can be spectacular.

Just realize that biotech-sector estimates -- especially those that go several years out -- can be even more unreliable than those of other groups.
In keeping with TSC's editorial policy, Lichtenfeld doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships.

Marc Lichtenfeld was previously an analyst at Avalon Research Group and The Weiss Group and a trader at Carlin Equities. He holds NASD 86, 87, 7 and 63 licenses. His prior journalism experience includes being a reporter/anchor for On24 in San Francisco and a managing editor of InvestorsObserver, a personal finance Web site. He is a graduate of the State University of New York at Albany. He appreciates your feedback; click here to send him an email.