The Basics: How to Value a Biotech Stock
Investors typically use several generally recognized methods for analyzing a stock’s value. Basic ratios such as P/E (price-to-earnings), EPS growth, margins and more provide an overview of how a stock is performing. Normally, these ratios work to compare stocks with the broader markets and can reveal whether a stock is under-valued, fairly priced, or over-valued.
But the biotech sector doesn’t necessarily play by the same rules. Because of the nature of the industry – scientific research, FDA approval, and patents – biotech stocks can be extremely lucrative and volatile. Typical fundamental analytical methods like P/E ratio comparisons don’t make sense for this type of stock, so investors need to know the unique nomenclature of the industry in order to understand what to buy or sell.
Key Ratios for Biotechnology Stocks
There are three main ratios in the biotech sector that investors need to be aware of. Some of them might be familiar, while others might be ratios you never thought to look at.
Current Ratio – This ratio tells investors how a company is doing financially. In other words, what is the ability of the company to pay its short term and long term debts. To find the current ratio, you need to compare current assets to current liabilities. The higher the ratio, the more financially stable the company is, while a low ratio – especially under 1 – can be a red flag to investors that the company could be facing financial challenges.
Price-to-Earnings-to-Growth Ratio (PEG) – While the price-to-earnings ratio tells investors how expensive a stock is currently priced at, the PEG ratio provides a more complete picture by taking EPS growth into account, as well. A company that seems expensive based on its P/E might actually be a good deal if that company’s EPS growth rate is equally high.
Research and Development (R&D) to Sales Ratio – The biotech industry lives and dies on its research and development segment. A general rule of thumb is that the more is spent on R&D, the more spent on new, untested products. From an investment standpoint, a lower percentage is better. It tells investors that the company is able to generate profits from existing product lines and isn’t overextending itself on R&D that might turn out to be worthless.
How the Industry Works
Aside from research and development, biotech companies thrive on their patents. The protection of a biotech company’s intellectual property is paramount to success – the more patents owned, the more streams of revenue generated.
It might seem that new products should mean more revenue for a biotech, but the FDA approval process is nowhere near guaranteed and takes years to undergo fully. A new drug developed today would take years before it actually reaches the market – assuming that it can pass all of the FDA’s approval stages.
Investing in biotech can be a a lucrative, risky proposal. One way to add biotech to your portfolio is to use it as a risk mitigation tool. After all, because biotech tends to trade independently of the overall markets, a biotech stock can actually help you reduce overall volatility in your portfolio.