Understanding Cost of Capital in Biotechs' Valuation

I have based a lot of my analysis on this blog around financial models, specifically rNPV, which I have talked about many times. However, after a discussion on ViroPharma's (VPHM) Yahoo! Finance message board, I noticed that I never mentioned a key component to valuation, which is a company's cost of capital.

Cost of capital [COC] is a firm's expected cost to finance its operations. It consists of a weighted average of a company's cost of equity [COE] and cost of debt [COD]. COC is calculated with the following formula:

COC = [(Weight of Equity)* [COE]] + [(Weight of Debt)* [COD]]

For more information, Investopedia has several good articles that explain the components: Start with this one.

The estimate for COC is just as important as an estimate for a potential market for a drug when using rNPV. COC is the rate at which future cash flows are discounted back to the present, and underestimating COC can give you a rNPV number that would be too optimistic, and vice-versa. Present value calculations are very sensitive to changes in the discount rate.

This is why it is important for analysts to get the COC right, or at least caution on the high side.

Generally speaking, development-stage biotechs have a COC in the 20% range, while big-cap biotechs like Genentech (DNA) and Gilead (GILD) have COCs around 10-12%. The difference in COC has to do with the risk involved with investing. Genentech and Gilead have marketed products, with positive cash flows and profits and, therefore, less risk, so investors are willing to seek lower returns. However, development stage biotechs like GenVec (GNVC) or NeurogesX (NGSX) are highly risky, and investors want to be compensated for that risk.

Disclosure: I own shares of GILD and NGSX.