Using Real-Options Valuation Methods for a Biotechnology Firm∗

Many firms in the biotechnology industry have significant valuations despite having no product revenue because their products are in early stages of development. In the past ten to fifteen years investors have bid up the stock prices of firms showing promise of developing a blockbuster drug. Using the decision-tree and binomial-lattice methods we compare the value of a biotechnology firm to the sum of the values of its drug development projects. We compare our computed values of Agouron to actual market values at selected points in time during the development of Viracept, a drug used to treat HIV-positive patients. Values for Agouron were also found using a binomial lattice with the addition of a growth option, which was added because the development of an initial new molecular entity (NME) is similar to purchasing a call option on the value of a subsequent NME.