I’m reading an article on a hypothetical drug that’s coming to market in the next 6-7 years. The value of the drug is around $1 billion but it has a 35% chance of passing Phase I and II trials. As a result, the drug has a valuation of 350 million (i.e. $1B x 35%).
How does this make any sense? How can you use probabilities to value a drug here based on its probability of success?
I’ve read this in other areas too e.g. the probability of a product failure is 23% so if the product costs $100, the warranty should cost $23 (i.e. $100 x 23%).
I’ve tried to believe that this can be quantified e.g. for every 100 products we sell, 23 of them will fail (as percentages are out of 100) so we should charge a warranty of $23 since we will spend $2300 on fixing 100 products if those costs are not made back.
However, in the case of the drug pipeline, I don’t understand how this works. As far as I can deduce, for every 100 times you push the drug through, only 35 attempts will be successful. So, the drug will make you $350M for every time (on average) it passes a test. I don’t understand what the $350M means in this case.
Any help to wrap my head around this concept would be appreciated!
In: 55
Classic expected value calculation. Many things in life are probabilistic, or rather are not certain in outcome so you can use these simple calculations to assess the value you expect out of something over a sample size.
35% chance drug goes to market and makes 1 billion essentially tells you that the break even point on investing in this drug is 350 million, or 35% of 1 billion. If the drug costs 300 million to produce, the investment is a winner, or what you call “+EV”. If the drug cost 500 million to produce, your investment has now become “-EV”.
Fwiw the calculations for valuing investments like this is no different to running EV calculations for say lotteries, poker etc. You have probabilistic outcomes and each has a $ value associated with them.
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