Project valuation in the pharmaceutical industry: a comparison of least‐squares Monte Carlo real option valuation and conventional approaches

Abstract

Least‐squares Monte Carlo simulation (LSM) is a promising new technique for valuing real options that has received little or no attention in the pharmaceutical industry. This study demonstrates that LSM can handle complex valuation situations with multiple uncertainties and compounded American‐type options. The limited application of real option valuation (ROV) in the pharmaceutical industry is remarkable, given the importance of accurate project valuation in an industry that requires large investments in high‐risk projects with long pay‐back periods, which is furthermore suffering from ever‐increasing development costs and shrinking profit margins. The LSM model developed in this study is constructed as an extension of a discounted cash flow model that should be familiar to economists active in the pharmaceutical industry. A number of pharmaceutical projects have been evaluated using LSM ROV, binominal real option valuation and expected net present value techniques. The different results yielded by these methods are explained in terms of differences in risking assumptions and ability to capture the value of flexibility. The analysis provides a framework to introduce the basic concepts of real option pricing to a non‐specialist audience. The LSM model illustrates the potential for real‐life commercial assessment as the versatility of the technique allows for an easy customisation to specific business problems.

R&D Project Valuation Considering Changes of Economic Environment: A Case of a Pharmaceutical R&D Project

“…However, historical data indicates that the financial outcomes measured, such as commodity price and company earnings, are more likely to be governed by a mean-reverting stochastic process rather than a GBM [26,31,32]. While a GBM generates extreme cash flows near the expiration when compared to initial cash flows, the market size of a specific drug is governed by the number of patients with the target disease throughout the lifecycle of a drug [17]. In our study, the underlying asset is a project of new drug development and its value is total future cash flows.…”

“…DiMasi et al [23] reported that only one out of six new drug developments that enter clinical studies yield a marketable drug. Market risks and uncertainties are associated with commercial potentials, which are affected by the size of the population with the target disease, new competing drugs entering the market, third party payer's payment regulations, and the economy in general [17,30].…”

“…We propose a new real option valuation model which simultaneously employs mean-reverting stochastic process and time-varying parameters based on a binomial lattice approach. The mean-reversion assumption and a regime switching technique can more realistically capture the characteristics of R&D projects and the structural changes of economic conditions [17,27]. Additionally, as Mun [28] indicated, a lattice-based approach is relatively intuitive and can therefore be accepted easily.…”

“…Myers and Howe [15] and Schwartz [16] proposed an MCS approach, which can easily model general stochastic processes. Willigers and Hansen [17] strengthened the MCS approach by adding the assumption that the logarithm of sales of a drug is governed by a mean-reverting stochastic process, which is closer to reality. However, the MCS approach is computationally intensive and complex compared to a lattice-based model.…”

“…The ROV has highlighted sustainable management to properly realign the firm's strategies according to risks from uncertainties related with the business environment [8,9]. Scholars proposed a binomial lattice model [10][11][12], option models compounding Geske's and the fuzzy model [13,14], the Monte Carlo simulation (MCS) approach with general stochastic processes and assumption of sales of a drug governed by a mean-reverting stochastic process [15][16][17], and the mean-reverting binomial lattice model [18] for the valuation of R&D projects in various industries.…”