a decision tree valuation of a pharmaceutical company with...
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AdecisiontreevaluationofapharmaceuticalcompanywithonedrugintheFDApipeline…
Aswath Damodaran
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Test
Abandon
Succeed
70%
Fail
30%-$50
-$140.91
Types 1 & 2
Type 2
Type 1
Fail
10%
10%
30%
Develop
Abandon
Develop
Abandon
Develop
Abandon
Succeed
Succeed
Succeed
Fail
Fail
Fail
75%
25%
80%
20%
80%
20%-$328.74
-$328.74
-$328.74
$585.62
-$328.74
-$97.43-$366.30
-$366.30
$887.05
50%
$50.36
$93.37
$573.71
-$143.69
$402.75
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KeyTestsforRealOptions
Aswath Damodaran
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¨ Isthereanoptionembeddedinthisasset/decision?¤ Canyouidentifytheunderlyingasset?¤ Canyouspecifythecontingencyunderwhichyouwillgetpayoff?
¨ Isthereexclusivity?¤ Ifyes,thereisoptionvalue.¤ Ifno,thereisnone.¤ Ifinbetween,youhavetoscalevalue.
¨ Canyouuseanoptionpricingmodeltovaluetherealoption?¤ Istheunderlyingassettraded?¤ Cantheoptionbeboughtandsold?¤ Isthecostofexercisingtheoptionknownandclear?
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I.OptionsinProjects/Investments/Acquisitions
Aswath Damodaran
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¨ Oneofthelimitationsoftraditionalinvestmentanalysisisthatitisstaticanddoesnotdoagoodjobofcapturingtheoptionsembeddedininvestment.¤ Thefirstoftheseoptionsistheoptiontodelaytakingainvestment,whenafirmhasexclusiverightstoit,untilalaterdate.
¤ Thesecondoftheseoptionsistakingoneinvestmentmayallowustotakeadvantageofotheropportunities(investments)inthefuture
¤ Thelastoptionthatisembeddedinprojectsistheoptiontoabandonainvestment,ifthecashflowsdonotmeasureup.
¨ Theseoptionsalladdvaluetoprojectsandmaymakea“bad” investment(fromtraditionalanalysis)intoagoodone.
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A.TheOptiontoDelay
Aswath Damodaran
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¨ Whenafirmhasexclusiverightstoaprojectorproductforaspecificperiod,itcandelaytakingthisprojectorproductuntilalaterdate.
¨ Atraditionalinvestmentanalysisjustanswersthequestionofwhethertheprojectisa“good” oneiftakentoday.
¨ Thus,thefactthataprojectdoesnotpassmustertoday(becauseitsNPVisnegative,oritsIRRislessthanitshurdlerate)doesnotmeanthattherightstothisprojectarenotvaluable.
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ValuingtheOptiontoDelayaProject
Aswath Damodaran
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Present Value of Expected Cash Flows on Product
PV of Cash Flows from Project
Initial Investment in Project
Project has negativeNPV in this section
Project's NPV turns positive in this section
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Example1:Valuingproductpatentsasoptions
Aswath Damodaran
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¨ Aproductpatentprovidesthefirmwiththerighttodeveloptheproductandmarketit.
¨ Itwilldosoonlyifthepresentvalueoftheexpectedcashflowsfromtheproductsalesexceedthecostofdevelopment.
¨ Ifthisdoesnotoccur,thefirmcanshelvethepatentandnotincuranyfurthercosts.
¨ IfIisthepresentvalueofthecostsofdevelopingtheproduct,andVisthepresentvalueoftheexpectedcashflowsfromdevelopment,thepayoffsfromowningaproductpatentcanbewrittenas:
Payofffromowningaproductpatent =V- I ifV>I=0 ifV≤I
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PayoffonProductOption
Aswath Damodaran
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Present Value ofcashflows on product
Net Payoff tointroduction
Cost of product introduction
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ObtainingInputsforPatentValuation
Input Estimation Process
1. Value of the Underlying Asset • Present Value of Cash Inflows from taking projectnow
• This will be noisy, but that adds value.2. Variance in value of underlying asset • Variance in cash flows of similar assets or firms
• Variance in present value from capital budgetingsimulation.
3. Exercise Price on Option • Option is exercised when investment is made.• Cost of making investment on the project ; assumed
to be constant in present value dollars.4. Expiration of the Option • Life of the patent
5. Dividend Yield • Cost of delay• Each year of delay translates into one less year of
value-creating cashflowsAnnual cost of delay = 1
n
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ValuingaProductPatent:Avonex
Aswath Damodaran
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¨ Biogen,abio-technologyfirm,hasapatentonAvonex,adrugtotreatmultiplesclerosis,forthenext17years,anditplanstoproduceandsellthedrugbyitself.
¨ Thekeyinputsonthedrugareasfollows:¤ PVofCashFlowsfromIntroducingtheDrugNow=S=$3.422billion¤ PVofCostofDevelopingDrugforCommercialUse=K=$2.875billion¤ PatentLife=t=17yearsRisklessRate=r=6.7%(17-yearT.Bond rate)¤ VarianceinExpectedPresentValues=s2 =0.224(Industryaveragefirmvariancefor
bio-techfirms)¤ ExpectedCostofDelay=y=1/17=5.89%
¨ Theoutputfromtheoptionpricingmodel¤ d1=1.1362 N(d1)=0.8720¤ d2=-0.8512 N(d2)=0.2076CallValue=3,422exp(-0.0589)(17)(0.8720)- 2,875exp(-0.067)(17) (0.2076)=$907million
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TheOptimalTimetoExercise
Aswath Damodaran
31 Patent value versus Net Present value
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17 16 15 14 13 12 11 10 9 8 7 6 5 4 3 2 1Number of years left on patent
Val
ue
Value of patent as option Net present value of patent
Exercise the option here: Convert patent to commercial product
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Valuingafirmwithpatents
Aswath Damodaran
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¨ Thevalueofafirmwithasubstantialnumberofpatentscanbederivedusingtheoptionpricingmodel.
ValueofFirm=Valueofcommercialproducts(usingDCFvalue+Valueofexistingpatents(usingoptionpricing)+(ValueofNewpatentsthatwillbeobtainedinthe
future– Costofobtainingthesepatents)¨ Thelastinputmeasurestheefficiencyofthefirmin
convertingitsR&Dintocommercialproducts.Ifweassumethatafirmearnsitscostofcapitalfromresearch,thistermwillbecomezero.
¨ Ifweusethisapproach,weshouldbecarefulnottodoublecountandallowforahighgrowthrateincashflows(intheDCFvaluation).
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ValueofBiogen’sexistingproducts
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¨ Biogenhadtwocommercialproducts(adrugtotreatHepatitisBandIntron)atthetimeofthisvaluationthatithadlicensedtootherpharmaceuticalfirms.
¨ Thelicensefeesontheseproductswereexpectedtogenerate$50millioninafter-taxcashflowseachyearforthenext12years.
¨ Tovaluethesecashflows,whichwereguaranteedcontractually,the pre-taxcostofdebtoftheguarantorswasused:PresentValueofLicenseFees=$50million(1– (1.07)-12)/.07
=$397.13million
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ValueofBiogen’sFutureR&D
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¨ Biogencontinuedtofundresearchintonewproducts,spendingabout$100milliononR&Dinthemostrecentyear.TheseR&Dexpenseswereexpectedtogrow20%ayearforthenext10years,and5%thereafter.
¨ Itwasassumedthateverydollarinvestedinresearchwouldcreate$1.25invalueinpatents(valuedusingtheoptionpricingmodeldescribedabove)forthenext10years,andbreakevenafterthat(i.e.,generate$1inpatentvalueforevery$1investedinR&D).
¨ Therewasasignificantamountofriskassociatedwiththiscomponentandthecostofcapitalwasestimatedtobe15%.
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ValueofFutureR&D
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Yr ValueofPatents R&DCost ExcessValue PV(at15%)
1 $150.00 $120.00 $30.00 $26.09
2 $180.00 $144.00 $36.00 $27.22
3 $216.00 $172.80 $43.20 $28.40
4 $259.20 $207.36 $51.84 $29.64
5 $311.04 $248.83 $62.21 $30.93
6 $373.25 $298.60 $74.65 $32.27
7 $447.90 $358.32 $89.58 $33.68
8 $537.48 $429.98 $107.50 $35.14
9 $644.97 $515.98 $128.99 $36.67
10 $773.97 $619.17 $154.79 $38.26
$318.30
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ValueofBiogen
Aswath Damodaran
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¨ ThevalueofBiogenasafirmisthesumofallthreecomponents– thepresentvalueofcashflowsfromexistingproducts,thevalueofAvonex(asanoption)andthevaluecreatedbynewresearch:Value=Existingproducts+ExistingPatents+Value:FutureR&D
=$397.13million+$907million+$318.30million=$1622.43million
¨ SinceBiogenhadnodebtoutstanding,thisvaluewasdividedbythenumberofsharesoutstanding(35.50million)toarriveatavaluepershare:¤Valuepershare=$1,622.43million/35.5=$45.70
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TheRealOptionsTest:PatentsandTechnology
Aswath Damodaran
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¨ TheOptionTest:¤ UnderlyingAsset:Productthatwouldbegeneratedbythepatent¤ Contingency:
n IfPVofCFsfromdevelopment>Costofdevelopment:PV- Costn IfPVofCFsfromdevelopment<Costofdevelopment:0
¨ TheExclusivityTest:¤ Patentsrestrictcompetitorsfromdevelopingsimilarproducts¤ Patentsdonotrestrictcompetitorsfromdevelopingotherproductstotreatthesamedisease.
¨ ThePricingTest¤ UnderlyingAsset:Patentsarenottraded.Notonlydoyouthereforehavetoestimatethepresentvaluesand
volatilitiesyourself,youcannotconstructreplicatingpositionsordoarbitrage.¤ Option:Patentsareboughtandsold,thoughnotasfrequentlyasoilreservesormines.¤ CostofExercisingtheOption:Thisisthecostofconvertingthepatentforcommercialproduction.Here,
experiencedoeshelpanddrugfirmscanmakefairlypreciseestimatesofthecost.
¨ Conclusion:Youcanestimatethevalueoftherealoptionbutthequalityofyourestimatewillbeadirectfunctionofthequalityofyourcapitalbudgeting.Itworksbestifyouarevaluingapubliclytradedfirmthatgeneratesmostofitsvaluefromoneorafewpatents- youcanusethemarketvalueofthefirmandthevarianceinthatvaluetheninyouroptionpricingmodel.
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Example2:ValuingNaturalResourceOptions
Aswath Damodaran
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¨ Inanaturalresourceinvestment,theunderlyingassetistheresourceandthevalueoftheassetisbasedupontwovariables- thequantityoftheresourcethatisavailableintheinvestmentandthepriceoftheresource.
¨ Inmostsuchinvestments,thereisacostassociatedwithdevelopingtheresource,andthedifferencebetweenthevalueoftheassetextractedandthecostofthedevelopmentistheprofittotheowneroftheresource.
¨ DefiningthecostofdevelopmentasX,andtheestimatedvalueoftheresourceasV,thepotentialpayoffsonanaturalresourceoptioncanbewrittenasfollows:
Payoffonnaturalresourceinvestment =V- X ifV>X=0 ifV≤X
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PayoffDiagramonNaturalResourceFirms
Aswath Damodaran
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Value of estimated reserve of natural resource
Net Payoff onExtraction
Cost of Developing Reserve
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EstimatingInputsforNaturalResourceOptions
Input Estimation Process
1. Value of Available Reserves of the Resource • Expert estimates (Geologists for oil..); Thepresent value of the after-tax cash flows fromthe resource are then estimated.
2. Cost of Developing Reserve (Str ike Price) • Past costs and the specifics of the investment
3. Time to Expiration • Relinqushment Period: if asset has to berelinquished at a point in time.
• Time to exhaust inventory - based uponinventory and capacity output.
4. Variance in value of underlying asset • based upon variability of the price of theresources and variability of available reserves.
5. Net Production Revenue (Dividend Yield) • Net production revenue every year as percentof market value.
6. Development Lag • Calculate present value of reserve based uponthe lag.
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ValuingGulfOil
Aswath Damodaran
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¨ GulfOilwasthetargetofatakeoverinearly1984at$70pershare(Ithad165.30millionsharesoutstanding,andtotaldebtof$9.9billion).¤ Ithadestimatedreservesof3038millionbarrelsofoilandtheaveragecostofdevelopingthesereserveswasestimatedtobe$10abarrelinpresentvaluedollars(Thedevelopmentlagisapproximatelytwoyears).
¤ Theaveragerelinquishmentlifeofthereservesis12years.¤ Thepriceofoilwas$22.38perbarrel,andtheproductioncost,taxesandroyaltieswereestimatedat$7perbarrel.
¤ Thebondrateatthetimeoftheanalysiswas9.00%.¤ Gulfwasexpectedtohavenetproductionrevenueseachyearofapproximately5%ofthevalueofthedevelopedreserves.Thevarianceinoilpricesis0.03.
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ValuingUndevelopedReserves
Aswath Damodaran
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¨ Inputsforvaluingundevelopedreserves¤ Valueofunderlyingasset=Valueofestimatedreservesdiscountedbackforperiod
ofdevelopmentlag=3038*($22.38- $7)/1.052 =$42,380.44¤ Exerciseprice=Estimateddevelopmentcostofreserves=3038*$10=$30,380
million¤ Timetoexpiration=Averagelengthofrelinquishmentoption=12years¤ Varianceinvalueofasset=Varianceinoilprices=0.03¤ Risklessinterestrate=9%¤ Dividendyield=Netproductionrevenue/Valueofdevelopedreserves=5%
¨ Basedupontheseinputs,theBlack-Scholesmodelprovidesthefollowingvalueforthecall:d1=1.6548 N(d1)=0.9510d2=1.0548 N(d2)=0.8542CallValue=42,380.44exp(-0.05)(12)(0.9510)-30,380(exp(-0.09)(12) (0.8542)
=$13,306million
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ValuingGulfOil
Aswath Damodaran
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¨ Inaddition,GulfOilhadfreecashflows tothefirmfromitsoilandgasproductionof$915millionfromalreadydevelopedreservesandthesecashflows arelikelytocontinuefortenyears(theremaininglifetimeofdevelopedreserves).
¨ Thepresentvalueofthesedevelopedreserves,discountedattheweightedaveragecostofcapitalof12.5%,yields:¤ Valueofalreadydevelopedreserves=915(1- 1.125-10)/.125=$5065.83
¨ AddingthevalueofthedevelopedandundevelopedreservesValueofundevelopedreserves =$13,306millionValueofproductioninplace =$5,066millionTotalvalueoffirm =$18,372millionLessOutstandingDebt =$9,900millionValueofEquity =$8,472millionValuepershare =$8,472/165.3 =$51.25