Optimal evaluation methodology: estimate discount rates
In this paper we address the issues of estimating discount rates, a key board supervision prerogative based on its strategic impact . In our final paper we shall propose a methodology for using the results in fund raising rounds or as licensing road maps.
In previous articles we have taken the eye of the practitioner to propose a new look at valuations, with company governance as the key “customer”: strategic decision making must focus on hypotheses and the likelihood of outcomes.
1. Risk
There is much terminology confusion between risk-premium, discount rate, WACC, CAPM, etc. And the amount of work generated with sophisticated mathematical models currently contributes more to confusion than to clarity for the non-academic practitioner and decision maker [1] .
Let’s use “ volatility embedded in the estimates of future value of a parameter” as a proxy for “risk”.
Volatility can be expressed as a continuous function/ distribution or a discrete function (e.g. yes/no; 1 or 0; etc.).
The former is suited for variations of estimates around an anchor point, the latter for estimates of anchor points.
A good example is the chart above where peak sales estimates are plotted for each retained positioning scenario.
It is common practice that more risk comes with a higher discount rate. But when it comes to determine which risk comes with which premium there is still no generally accepted method by both the practitioners –to which we belong- and the academia.
“Conflicting approaches to calculating risk have led to varying estimates of the equity risk premium from 0 percent to 8 percent—although most practitioners use a narrower range of 3.5 percent to 6 percent. …”[3].
2 Market risk: Continuous (uncertainty) and discrete (scenario) functions
Non diversifiable commercialization uncertainties are related to geo-political tensions, competitive developments, new regulations.
(1) Pal = Pf+ Pm
Pal = “after launch” premium;
Pf = Risk free premium;
Pm = non diversifiable market risk premium.
The current debate concerns which discount rate to use to calculate the value of future commercial cash flows obtained with the proposed scenario building methodology.
The theory calls for Pf while most non financial decision makers will go for Pal .
However, If the project extends far enough in the future, the development phase risk premiums will make the most significative difference for early phase decision making.
3 Development risks: discrete values (pass rates)
Early in projects development phase outcomes are discrete in terms of technical results and potential product profiles.
Numerous references exist –e.g. Tufts Center for the Study of Drug Development – with data bases available for “pass rates”.
Evaluators ought to be very careful in selecting which pass rates to use as most published in articles, web-sites and institutions do not necessarily reflect the nature of their own project nor do they necessarily apply to their company’s track record. Due diligence is essential here.
According to the CAPM theory pass rates should not have an influence on the discount rate, as they are theoretically diversifiable risks.
In reality however there is an observable direct relationship between success rate and risk premium, with discovery stage biotechs facing >20% discount rates, clinical stage companies a lower one and marketing stage companies an 8% market risk premium - the average market risk premium of 7% computed by McKinsey for the last decades, based on GDP.
For the skeptical P/E ratios is another metric of the same perception of risk.
Two additional premiums are added by the market in the evaluation of global risk
(2) Pal = Pf+ Pm + Pi + Pc
Pi industry related premium and
Pc company related premium generally accepted as reflecting the risk associated with the company track record on delivering on promises [1] [2].
This approach has led to the Market Derived Capital Asset Pricing Model (MCPM), which tends to overstate the influence of company and industry specific risks.
Myers and Shyam-Sunder explain why, given the implicit leverage associated with R&D, systematic risk will likely increase with R&D intensity and be greater for early stage projects compared with more mature projects.
4 Estimating risk premiums
How to assess the risk premium as a function of development stage? And for which purpose?
Modern add-ons assist in deriving estimates for phase related risk premiums. You need to have 2 points and to realize that the risk aversion is increasing as risk increases s reflected in the diagram on the left and/or in Table 1 below.
Which risk premiums would you use to estimate the value at the entry of the different phases of the project? Which risk premiums to evaluate the project as a whole? The answer lies with your objective: are you looking at a value or estimating a price? Or at the value of project in the hands of company A, or in the hands of management team B? Or just at the current phase of development as a short term investment ?
Table 1: Risk premiums, risk related discount rates, whole project
5 Next steps
In the next and final article of this serial we shall develop the tools and recommended methodologies to
i) obtain meaningful summary tables of results and
ii) to work out strategic decision making based on them.
6 Marginal vs fully costed cash flows
Should a risk premium be added when only direct marginal cash flows are used in project projections? Proponents argue that marginal cash flows are more volatile. Even if correct the issue remains as to how to compute the associated risk premium and for which purpose.
In our practice we consider all project related cash-flows as marginal, and we incorporate fixed costs analysis when dealing with company valuations.
About the author: Jean-Louis Roux Dit Buisson owns an MSc from MIT and an MBA from INSEAD and can be reached at rouxbuisson@alum.mit.edu
He is lecturer of Entrepreneurship at the Grenoble Management School in France. He is founder of Foro Ventures, a company dedicated to provide assistance and interim management for top-line growth projects and turn-arounds. Jean-Louis has experience with B2B industries and high technology sectors.
References
1. Cost of Capital for Pharmaceutical, Biotechnology, and Medical Device Firms, Scott E. Harrington Alan B. Miller Professor Health Care Management The Wharton School University of Pennsylvania
2. Myers, S. and L. Shyam-Sunder, 1996, Measuring pharmaceutical industry risk and the cost of capital, in R. Helms, Washington, D. C., American Enterprise Institute.
3. Mc Kinsey quarterly OCTOBER 2002 • Marc H. Goedhart, Timothy M. Koller, and Zane D. Williams
4. News in Avance, Valuation in Life Sciences, January 20085. J. La Mattina; http://www.forbes.com/sites/johnlamattina/2012/06/19/mckinsey-decrees-that-the-pharma-rd-productivity-gains-are-real/?goback=.gde_4322249_member_127381082
