MSB Trading - 2019, page-411

Lower Volatility = Higher Long Term Price and lower finance costs

I'm actually pleased that the price has been stable recently. Volatility is bad for valuations and increases financing costs.

If MSB can rid itself of the wild rises and fall it will be in a much better long term position.

It's totally counter productive to get the price running up to $2 only to fall back to $1, unless it can hold that price and then continue to move ahead.

I'm in this for much higher prices than the recent highs, and it can get there with proof of the technology through trial success, adequate funding (hopefully aided by pharma deals and upfront payments), and eventual sales, profits and dividends.

How volatility affects valuations
The main analyst valuations use discount rates of 15% to 30%.

This discount rate is justified by an estimate of the beta of the stock and therefore the cost of capital. If you use a beta of 1.8 to 2 (which is in line with other similar stocks) you can backsolve for a cost of equity capital of around 15%. You then use this 15% rate to discount future cash flows. This is a bit of a fudge which seems sensible but bears no relationship to the actual beta of MSB.

The lower the discount rate, the less you discount future cash flows and the higher the value of the company.

This all seems reasonable from rules of thumb - only problem is that MSB's observed beta is closer to zero, ie MSB's price moves in both the short and long term are nothing to do with moves in the general stock market. So, MSB should actually be a good "diversifier" in a portfolio, and could add dramatically to a portfolio's risk adjusted returns if it is successful in the longer term.

I think these 15-30% rates are too high, particularly given probability discounts on top of this amount. The discount rate in a Net Present Value (NPV) calculation is supposed to take risk into account, including probability of success of various products. Adding a probability discount actually means the implied discount rate is much higher.

For instance, the NPV of $1m in 10 years at 30% pa discount rate is only $72,538 (that's right a discount of nearly 93%!) then a 70% probability discount takes the NPV down to $21,761 (or a reduction in total value of 98%!!). That's equivalent to a probability adjusted NPV discount rate of 46.6% pa.

In the same way, a 15% discount rate on a payment received in 10 years plus 70% probability discount gives a total reduction in value of 92.6%, equivalent to an annual probability adjusted discount rate of 30% pa.

These are the discount rates being used in valuations which STILL give a NPV of $4 to $6 per share. That's pretty spectacular!!

The discounts are obviously much less for payments received in the next 12 months - the problem is that these amounts are negative (ie the cash burn before we get sales) - then for the first few years the main part of the cash flow is in our smallest product being Childhood aGVHD.

So this way of calculating MSB's NPV is highly negative for the potential value of the stock.

What happens to valuations if volatility dies down?

If we use a 10% discount rate as the company matures, and drop the probability discount, a payment of $1m due in 10 years has an NPV of $385,453. That is worth nearly 18x more than the example above with a 30% discount rate and 70% probability discount. It is 5.2x more than the 15% discount rate and 70% probability discount.

This is why it is important to get the share price to a sustainable base price, lower the volatility and then start to build a sustainable growth rate in the share price from there. The share price rate of growth can be high, as long as it is sustainable and we don't get the big falls again.

That way we can build towards much higher share prices over the longer term.

Potential price targets

A share price of $4-6 in 5 years time implies an annual return of 27.2% pa to 38% pa. That's a fantastic return, well above the cost of capital - and note that the main US analysts covering MSB have this as a price target in only 12 months.

The last time MSB did a major US partnership, with Cephalon, the share price ran to $10. If there are 25% more shares on issue now, that means an equivalent share price of $8 (depending on how good the deal is).

The company has never been in a stronger position in terms of the technology, with recent licence extensions in Japan, new partner in China, US phase 3 trials in heart and lower back pain fully enrolled and phase 3 aGVHD trial completed with a successful primary endpoint and a BLA about to be filed next month.

The Prof has emphasised that negotiations with pharma are at "an advanced" stage and (despite people despairing that no deal has been done yet) the progress in discussions can only be improved by all this progress. He signed off the last conference call telling us that the next 6 months are likely to be the most exciting in the company's history - that's pretty dramatic when you think about the Cephalon period when the share price ran to $10. Maybe he's talking about progress in trials and FDA approval rather than share price, but the two go hand in hand, especially if there's a big pharma deal at the same time.

So, I'm happy volatility is low, and I believe the best way forward for our long term prosperity is a share price that doesn't get ahead of itself and which is building sustainable growth with low volatility.

As a final observation on volatility, the recent drop in volatility has coincided with a massive drop off in daily shorting volumes over the past month and a drop in the shorting pool to around 350,000 shares - ie there just isn't the availability of stock to borrow and short. This all looks like the calm before the storm.