Handling complex decisions in the development of new drugs in pharmaceutical firms
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Handling Complex Decisions in the Development of New Drugs in Pharmaceutical Firms. Cassimon, Engelen and Yordanov. FUR XII , LUISS, Roma , Italy, 22-26 June 2006. Valuation of pharma companies.

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Handling complex decisions in the development of new drugs in pharmaceutical firms

Handling Complex Decisions in the Development of New Drugs in Pharmaceutical Firms

Cassimon, Engelen and Yordanov

FUR XII, LUISS, Roma, Italy, 22-26 June 2006


Valuation of pharma companies

Valuation of pharma companies

  • Financial analysts typically split the value of a pharmaceutical company in three building blocks:

(i) existing marketed products;

(ii) new products in the mid to late stage of development (phase II and III of the clinical testing);

(iii) early R&D.

Valuation is problematic

with current models


Real option characteristics of projects

Real option characteristics of projects

  • Financial option: right (not an obligation) to buy or sell a certain asset at specific moments at a predetermined price

  • What are real options?

    • Recognizing the project itself or certain components as options

    • A project is an option, whereby the company obtains the right to all future FOCFs the project generates, in exchange for a predetermined price (investment cost of the project)

  • Different types of real options

    • Growth options, options to delay, etc.


Handling complex decisions in the development of new drugs in pharmaceutical firms

Real option approach to R&D

  • Benefits of real option approach compared to traditional models:

    • Can handle operational flexibility with respect to investment decisions

      • Abandonnement, delay or adjustment of projects, e.g. stop R&D of particular drug

    • Takes into account the strategic value of a project because of its interdependence with future projects

      • R&D give option to follow-up projects

      • Real option models are better suited to value R&D


Typical example of a growth option

I

large project

FOCF

success

Follow-up project?

Pilot project

start

t T

failure

Real option value (ROV)

typical: NPV < 0

Typical example of a growth option

Project’s value = NPV(pilot) + ROV (follow-up)  if >0, then invest


Extending the growth option

Extending the growth option

Growth option

Extension to multiple growth options

Sequential option

Application to a ‘regulated’ sequential option

Sequential drug development option


The drug approval process

Discovery

(2-10 years)

Preclinical Testing

Laboratory and animal testing

Clinical Phase I

20-80 healthy volunteers used to

determine safety and dosage

Clinical Phase II

100-300 patient volunteers used to

look for efficacy and side effects

Clinical Phase III

1000-5000 patient volunteers used to

monitor adverse reactions to long-term use

FDA Approval

Additional Post-

Marketing Testing

The drug approval process

years

3

7

10

14

0


Opening the r d black box

Opening the R&D black box


Development of a new drug

fundamental

research

Development of a new drug

commercialisation

approval by

government

NPV1

success

clinical test phase 3

clinical test phase 2

success

failure

NPV2

success

clinical test phase 1

failure

pre-clinical test phase

success

failure

success

failure

success

failure

failure


R d on new drug as a chain of options

R&D on new drug as a chain of options

(a)first option– decision to start preclinical phase;

(b)second option– decision to start first clinical trial phase;

(c)third option –decision to start second clinical trial phase;

(d)fourth option– decision to start third clinical trial phase;

(e) fifth option–decision to file for regulatory approval;

(f) sixth option – decision to launch the new drug on the market.


How to value this chain of real options

How to value this chain of real options?

  • Chain of real options in drug development can be seen as a case of compound option models

  • Geske (1979) – 2-fold compound option (option on an option)

  • R&D of new drug – 6-fold compound option

  • We use the extended n-fold compound option model of Cassimon et al. (2004)

  • Programmed in Matlab


Case study

Case-study

Xandee Biochemical, Ltd.


Its research and product portfolio

INS-84

JR-32

FR-242

DIVE-4

MF-164

interim products

Its research and product portfolio

commerciali-

zation

preclinical

clinical I

clinical II

clinical III

FDA approval

  • MV of product portfolio is the sum of:

    • assets in place (interim products)

    • unexercised compound growth options (pipeline)


Valuation of r d and product portfolio

Valuation of R&D and product portfolio


Details of its drug development pipeline

Option

ti

Ki

V

n-fold COV

Panel A – Product JR-32 ( = 0.81; wacc = 23%) – Preclinical phase

1

1.5

8.3

2

2.5

29.1

3

4

55.7

4

6.5

14.1

5

8

50.6

81.7

30.4

Panel B – Product INS-84 ( = 0.64; wacc = 18%) – Preclinical phase

1

3

15.8

2

4

48.5

3

6

96.4

4

8.5

25.3

5

10.5

107.2

72.7

15.6

Details of its drug development pipeline

Legend: ti is the maturity date for the compound call option Ci (expressed in years), Ki is the exercise price for the

compound call option Ci,; V is the current value of the underlying project;  is the instantaneous standard deviation

of the project return; wacc is the risk-adjusted discount rate of the project and COV is the compound option value

based on the corresponding n-fold compound option model. Ki,, V, I and COV in million USD.


Details of its drug development pipeline1

Panel C – Product FR-242 ( = 0.78; wacc = 21%) – Clinical I phase

1

0.5

10.2

2

2

33.7

3

5

8.3

4

6.75

60.0

65.8

19.4

Panel D – Product DIVE-4 ( =0.63; wacc = 18%) – Clinical III phase

1

2

8.5

2

3.5

29.4

61.1

33.4

Panel E – Product MF-164 ( = 0.46; wacc = 15%) – Approval phase

1

1

25.2

43.8

16.2

Details of its drug development pipeline

Legend: ti is the maturity date for the compound call option Ci (expressed in years), Ki is the exercise price for the

compound call option Ci,; V is the current value of the underlying project;  is the instantaneous standard deviation

of the project return; wacc is the risk-adjusted discount rate of the project and COV is the compound option value

based on the corresponding n-fold compound option model. Ki,, V, I and COV in million USD.


Decomposition of its market value

Decomposition of its market value

  • 39% of its MV comes from early stage R&D

  • 86% of its MV comes from drug development pipeline

  • Only 14% of its MV comes from existing products


Conclusions

Conclusions

  • Product portfolio of a pharmaceutical firm consists of exercised (assets in place) and unexercised (growth opportunity) real options

  • Real option component can be valued using generalised n-fold compound option models

  • Benefits:

    • possible to decompose MV of product portfolio in different components linked to specific phases of drug development process

    • Better insight in different value blocks of pharmaceutical firm (over the full range of phases of drug development)


Contact information

If you have …

comments or suggestions,

proposals for research collaboration, or

proposals for consulting work,

… please contact us at:

[email protected]

Peter-Jan Engelen

Utrecht University, Vredenburg 138

3511BG Utrecht, Netherlands

Contact information


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