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).

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