Note, this is a RNPV DCF valuation, the structure is as follows:...

Note, this is a RNPV DCF valuation, the structure is as follows:

Biotechnology stocks are valued based on a risk adjusted DCF model, called a "RNPV" approach.

This means that the potential future FCF is being discounted first by a probability of success %, as its accounting for the risk of the drug clinical trial process by the peer indication average (say, Neurology Drugs Phase III success rate), THEN by the cost of capital (discount rate),

The FCF is where the total addressable market (TAM) and other drugs in the marketplace come in (aka, competition in the market). You then need to judge the TAM and see how much of that is taken by competing drugs in the space/estimate your drugs market penetration/peak sales.

For example: If you have a $1B TAM, with no existing drugs, and an expectation of a peak market penetration of 30%, then you have $300M in revenues per year. Say you're running at a 25% margins, after all other required capital for WC/CAPEX, thats ~$75M in FCF.

But youre in a clinical trial process with significant risk, and this future FCF of $75M isnt accounting for any of that risk of Phase III failure.

Therefore, you must risk adjust it at the probability of success. For Phase III, the peer neurology drug candidate is ~56% likely to pass phase III, and ~50% likely to from successful Phase II to FDA approval.

So you risk adjusted that $75M in FCF, through a 50% chance likelihood of success = accounts for $37.5M in FCF in fair value today.

Then you discount that FCF by the cost of capital (the discount rate) to account for time value of money.

Now what happens if you have a secondary indication? Well, you calculate the TAM, the competitors, the potential market penetration and peak sales, the year of launch, the future FCF... then you risk adjust it by the probability of success. But it isnt a phase III, instead its a phase I, and the neurology peer phase I -> approval probability of success is just 8.4%.

So you account for just 8.4% of the future FCF from that indication to todays fair value.

Hope that helps people know how the above model is constructed with the RNPV DCF methodology.