Valuing a research-driven firm is a challenging task. The static discounted cash flow (DCF) model fails to capture the value of R&D options. Pharmaceutical companies are, by their very nature, dependent on research products. These companies face an uncertain business environment. Roughly, one out of 10,000 explored chemicals becomes a prescription drug and only 30 per cent of drugs succeed in recovering their costs. Since the future of current R&D investments is uncertain, the traditional cash flow method may return a negative value of the future growth plan. Various studies have shown that the concept of real options can be applied to capture the value of R&D investments. Options give their owner the right (and not the obligation) to buy or sell assets at a pre-determined price (called the exercise or strike price) on or before an agreed expiry date. The underlying asset for which the option contract is made can be financial instruments (e.g., shares) or investment projects (e.g., expansion or acquisition or R&D investments). If the underlying assets are shares, such options are called ‘stock options.’ On the other hand, options on investment projects are known as ‘real options. This study shows how we can value a pharmaceutical company with potential research products in the pipeline. The traditional DCF method could hardly explain around 39 per cent of the market capitalization of the company. This is because the market price has already factored in the growth options — the possible growth from drug discovery initiatives, growth from joint venture initiatives, etc. The cash flow model fails to capture these future values. Real options model to value research products has significantly improved the valuation. We show that the underlying value of R&D investments is best recognized in option pricing model. With Indian patent laws following the footsteps of the WTO prescriptions (from 2005), Indian pharmaceutical companies cannot avoid making significant investments in R&D. The study reveals that unless the compounds under research have potential to be breakthrough drugs, it may be difficult to recover R&D investments. Therefore, attaining a reasonable global market share is critical for Indian pharmaceutical companies to exercise options. The Indian market for any high-investment research drug is comparatively small. Given the huge R&D costs of new drug discovery, it is impossible for a domestic manufacturer to recover the R&D costs from domestic sales. Capturing export market is vital to the success of any new drug. So far, not a single new drug has been fully developed in India (right from discovery to successful completion of all trials). Indian companies have acquired generic products, discovered alternative process of manufacturing a patented drug, and licensed out the compounds to multinational companies for clinical trials and commercialization. They have not taken the risk of completing the entire process of drug discovery on their own. But, things are changing now. Indian companies have realized the importance of having a strong R&D base and we may see some blockbuster drugs being manufactured in India. This, we hope, will further popularize the real options model of valuing R&D investments
Real Options and Discounted Cash Flow Analysis to Assess Strategic Investment Projects