Decomposing the Value of a Pharmaceutical Firm

Abstract

Traditional valuation tools such as discounted cash flow (DCF) models fail in valuing research and development (R&D)-intensive pharmaceutical firms adequately because most of the market value of the firm is embedded in unexercised real options whose future value is uncertain at this moment. From this basic insight, it follows that the (value of the) firm should optimally be characterised as a portfolio of real options, and also that compound option models should optimally be used to value the firm's 'products' based on the typical development process of new drugs. The overall market value of a pharmaceutical company can then be decomposed taking into account the firm's specific portfolio of 'products' being at different stages of the drug development process. In this paper, we develop the general structure and apply that framework to a stylised real-life example.

Keywords: R&D, real options, compound option model, pharmaceutical, value decomposition

JEL Classification: C6, G12, G24, G31