Valuation Techniques: Discounted Cash Flow, Earnings Quality, Measures of Value Added, and Real Options

ASSUMPTIONS

Because of the political environment regarding health care costs, much has been written recently about pharmaceutical R&D. For this study, we drew on the work of Myers and Howe (1997), U.S. Congress, Office of Technology Assessment (1993), DiMasi, Hansen, Grabowski, and Lasagna (1991), and Grabowski and Vernon to make assumptions about development costs, probabilities of success, and profitability of new drugs. All costs and revenues are stated in 1994 constant U.S. dollars.

Following Myers and Howe, we assumed that a drug reaching the market would fall into one of five quality categories: (1) dog, (2) below average, (3) average, (4) above average, or (5) breakthrough. A marketed drug has a 60 percent probability of being of average quality and a 10 percent probability of being in each of the other four categories. The revenues associated with each quality category are highly skewed, with the peak revenue for dog and below-average drugs being no more than $7.4 million a year and that of breakthrough drugs being more than $1.3 billion a year. The assumed revenue for each category by year after launch is shown in Figure 23.1. Peak annual revenue by category is as follows (in millions):

FIGURE 23.1 Revenue Streams for New Drugs by Quality Category

Sources: Data for first 13 years from Myers and Howe; data for remaining years from U.S. Congress, Office of Technology Assessment.

Breakthrough	$1,323,920
Above average	661,960
Average	66,200
Below average	7,440 ...