Relative valuation is performed by evaluating the assets of a company with the current market rate of comparable assets. So to perform relative valuation we need to determine the assets and obtain the market value for these identified assets and then convert those to standardized values so that the differences between different firms are handled. Almost 85% of the equity research reports are based on multiple valuations. Relative valuation is a more likely reflection of the market perceptions and moods than the DCF method.
These perceptions are important when a company is considering an IPO and investing on momentum based strategies. Relative valuation could lead to potentially undervalues assets. Intrinsic valuation is often called as absolute valuation and it involves calculating the present value of the company’s future cash flows. Calculation of intrinsic value has many challenges such as how to determine the growth of the company in absolute terms and how this would impact the cash flows as well.
Especially for pharmaceutical companies when they try to maintain their revenue growth rates, they really do emphasize on improving the number of new drugs in the pipeline. Pharmaceutical companies are also increasing the licensing of proprietary compounds or drugs like the sepsis and the diabetes drugs in this case. Pharmaceutical companies do enter into collaborations to help the costs of research and initial marketing of the drug.
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As the FDA has to approve all the drugs sold in the US a very important part of the evaluation is the financial implications of the drugs in the pipeline and although the Net Present Value is typically used in this calculation it does not include the market risks associated. So a method called the Real Options Valuation or the ROV is opten applied to the R&D investment decisions(Rogers and Maranas). Some models such at the OptFolio perceive the new product development as a series of “continuation/abandonment”(Rogers,Maranas) options and a decision tree is used to calculate the probabilities associated with the scenarios.
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