In the pharmaceutical and biotechnology industry (referred to collectively as biopharma), almost all valuation and investment decisions decisions are based on DCF-based risk-adjusted net present value. Indeed, several other financial metrics are used in concert with rNPV for optimal decision-making. There are several drivers that affect pharma valuation – one of the largest drivers of the value is the discount rate. In this article, we describe the hierarchy of discount rate usage in biopharma valuation with the overarching goal of assisting valuation users in selecting appropriate discount rates.
Plug-in Practitioners
The elementary, Level 1 usage sees discount rates as an input that is needed for the rNPV formula, i.e., a value that goes into the cell of the Excel spreadsheet or financial calculator. Often, usage at this level seeks an answer to “What discount rate are people currently using for the biotech sector ? or What is the discount rate this year for doing pharma valuations? ” In essence, the discount rate is a “plug and chug” activity at this level of usage.
Cost of Capital Considerers
Level 2 usage represents the next step on the ladder of discount rates for pharma and biotech valuation. The usage at this level incorporates the fact that the discount rate reflects the cost of capital. Level 2 usage tends to be more specific than Level 1 and normally seeks the answer to “What is the cost of capital?” rather than just the discount rate.
Needless to say, the cost of capital varies – for example, capital from venture capitalists is more expensive than capital from friends and family. Similarly, debt capital may be cheaper than equity capital. Since most companies have highly diverse capital structures, using a universal cost of capital may not be appropriate.
Asset Pricing Modelers for Discount Rate
Level 3 usage i.e., employing asset pricing models is further up the hierarchy of discount rates for biotech and pharma valuation. The usage at this level involves recognizing the models used to compute the cost of capital. Familiarity with applying various asset pricing models, particularly CAPM, is common. However, the utility is significantly enhanced by paying attention to the various input variables required for the CAPM model and considering their suitability for pharma valuation. For example, the beta used in capital markets is a regression coefficient – would this apply to early-stage pharma, biotech, or diagnostics assets that are not publicly traded? Similarly, using an appropriate risk-free rate is vital, considering the bond duration and country of issue.
WACC Weighers
At the top of the discount rate usage hierarchy for biopharma valuation is the use of WACC (Weighted average cost of capital). The usage at this level factors in that the cost of capital combines different capital types – primarily equity and debt. Usage at this level also involves understanding the tax shield associated with debt. Here, the emphasis should be on understanding:
- The cost of equity
- The cost of debt
- Tax rate
For the cost of equity, the levering, un-levering, and re-levering of beta should be considered. For the cost of debt, the cost of debt should reflect the market value of the debt – simply using book value or historical rates may not be appropriate. By definition, for a company entirely financed by equity, WACC will automatically adjust to the cost of equity. Similarly, incorporating the tax rate is vital to assess the value of the tax shield. The suitability of the tax rate should be evaluated from geographical, operational, and forward-looking perspectives. Valuation is sensitive to these factors, so it is vital to accurately calculate discount rates for valuations of biopharma assets and companies.
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