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!
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From the perspective of an investor and/or pharmaceutical company this valuation makes sense right? As an investor / company you want to invest your time and money in the most profitable projects. Since there are a lot of potential medicines you will need to establish criteria how to choose the right ones to invest in. This is one of the possibilities on how to do this. Key aspects in the decision making are indeed the total value or sales potential (the amount of people needing the medicine * the price that can be asked). The second key aspect is the chance the drug will be allowed to enter the market. In most countries the FAA or similar bodies are very strict and the drug must showcase a good positive effect, limited side effects and many other points. In general, 9/10 hypothetical drugs will not enter the market so you can imagine this is a crucial aspect in the decision making.
And you are right, the outcome of the value for your hypothetical drug is indeed either 0 (when not passing trials) or 1 billion (when passing) but since this will happen in 35% of the time it makes sense to value it like this, as it serves as a benchmark compared to other hypothetical drugs with other potential values and passing chances.
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