The search for value
Every time the markets rebound, investors deliberate whether this marks the bottom for share pricing and if so, might it be time to get in. However, for those of us who remain skeptical; we have seen too many spikes in momentum, resistance, confidence and resilience as second quarter earnings were good but will it last? Valuations provide indicators when compared to the rapid decline and slow moves to present market levels.
Biotechnology, diagnostic and medical device innovation are risky business; development is expensive and regulatory hurdles i.e. risks are very high. Biotech companies spend millions on drug development that might not even achieve regulatory approval from the FDA. When reviewing and evaluating small cap healthcare companies, cash might keep them going but what are three (3) fast and easy indicators or tools of comparison.
- Market value is the price of which a security can be traded. An efficient market hypothesis the market price is generally equal to or close to the fair value, but they are not always equal as investors update real-time information about development program advancements relative to clinical outcomes and initiatives. Hence, market value and fair value are not the same.
- Fair value is determined by a few objective and subjective factors; usually defined as an unbiased estimate of its potential of a developing program or asset for which a market price cannot be readily determined. There are multiple and methodical ways to calculate the fair value for a security, one way takes into account a discounted cash flow (DCF) models but don’t always calculating the risk of clinical trials. The objective factors are IP acquisition costs and development costs. The subjective factors that determine the fair market value include risk factors, capital costs as well as perception of its clinical utility. However, most methods of calculating fair value involve making predictions that may not be correct or are influenced by unpredictable factors. The impact of external market economics must be recognized.
- Enterprise Value could be considered the theoretical takeover price. In the event of a buyout, an acquirer would have to take on the company’s debt, but would pocket its cash. EV differs significantly from simple market capitalization in several ways, and many consider it to be a more conservative and accurate representation of a firm’s value. The value of a firm’s debt, for example, would need to be paid by the buyer when taking over a company, and thus EV provides a much more accurate takeover valuation because it includes debt in its value calculation.
There are plenty of sophisticated arguments that can be actualized; but, these quick indicators represent a helpful snapshot or rough calculation of a firm’s value. For the average investor, valuation remains a complicated means to benchmark a firm that is in its development stage; hence, quality equity research, when available provides additional interpretive data by which an informed decision may be calculated.
