Valuation of a Developmental Drug as a Real Option

Valuing a capital investment as a real option (or series of options) has advantages over standard DCF valuation when the investment creates the future flexibility to delay, abandon, or expand an element of the project based on the resolution of a major source of uncertainty. The uncertainty is generally dealt with using a “volatility” term that aims to reflect the variability in the future value of the underlying asset. But there are certain situations in which the uncertainty has a second dimension. For example, drugs in development can be abandoned either because of bad technical outcomes (the drug doesn't work) or unfavorable resolutions of market risk (though the drug works, its market potential turns out to be too limited). In an article published earlier in this journal , the authors illustrated the valuation of an early‐stage pharma R&D investment using a real options approach in which the market and technical risks were folded together into the volatility parameter. In this article, the authors explain why they have concluded that this is an incorrect approach and then show how to handle market and technical risk as two separate dimensions of risk in valuing an R&D program. The potential use of this technique extends beyond pharma and biotech R&D to any situation in which the outcome of an important uncertainty is independent of the resolution of market risk associated with the underlying asset.