Industry Description

The U.S. pharmaceutical industry, as defined by the U.S. Census Bureau, consists of companies primarily engaged in researching, developing, manufacturing and marketing drugs for human or veterinary use (NAICS 3254).  The industry consists of both brand name and generic drugs, with different companies specializing in each type.  Brand name drugs are patent protected formulations that are marketed under a specific brand name by the company that owns the patent.  Generic drugs are often administered in place of the brand-name drug once the formulation’s patent protection has expired and other companies are free to produce the same drug.

Within the U.S., brand name pharmaceutical manufacturing generates approximately 70-80 percent of total drug revenue over the past decade; generic drug manufacturing generates approximately 20-30 percent of total drug revenues.[1]  In terms of revenue growth, however, the generic industry has been outpacing brand name drugs in recent years.  Certain brand name and generic drugs are also approved for over-the-counter sale without a prescription.  The U.S. over-the counter (OTC) pharmaceutical industry is estimated to grow at 10.6% annually from 2016 to 2021, with large pharmaceutical companies focusing more on OTC.[2]

One might perceive the higher prices of brand name drugs as indications of superior quality.  However, the major difference between a brand name drug and its generic counterpart is neither chemistry nor quality, but whether the drug is currently under patent protection.  The high pricing of brand name drugs is the source for pharmaceutical firms to recoup their initial R&D investments.[3]  Nearly 8 in 10 prescriptions filled in the United States today are for generic drugs, and the use of generic drugs is growing.[4]

Within the U.S., the Food and Drug Administration (FDA) serves as the main regulatory body overseeing the pharmaceutical industry. The FDA heavily regulates the testing and approval process for new drugs before they are released.  Drug companies must undergo a series of tests and trials to provide evidence that their drugs are safe and effective for human use.  The FDA also regulates the marketing, labeling, and approved indications for drugs once they are allowed on the market.

Industry Trends

The pharmaceutical industry experienced numerous changes in recent years, primarily due to diminished pricing power, increased market competition, and regulatory changes.  A few of the most significant industry trends are:

  1. Healthcare reforms across the globe are expected to increase revenues and decrease margins at the same time. While domestic health care reform has achieved slow overall health care cost growth since 2010, the price for prescription drug spending experienced unexpected high growth over the same period.  In terms of volume of sales, generic drugs account for about 70 percent of the U.S. pharmaceutical market.  The demand for generic drugs is expected to continue growing as consumers are seeking more affordable choices.[5]
  2. Narrowing profit margins are to be expected for drug wholesalers with narrowing distribution channels. The industry has undergone a large brand-to-generic conversion in the past few years, with patents on many popular brand name drugs expiring in 2016.  The superior profits achieved by wholesalers in the last conversion is not likely to continue, as manufacturers limit the number of specialty pharmacies selected.
  3. Pharmaceutical companies are expected to continue to outsource generic manufacturing to emerging markets and consolidate supply chain in order to increase efficiency and reduce costs.[6] Pharmaceutical manufacturers will continue to market to end-users in the attempt to maintain market share as patents expire.
  4. The biotech segment is expected to continue to increase its share in the global pharmaceutical sector. Biotech drug sales were estimated at $289 billion in 2014 and are projected to grow to $445 billion by 2019, representing 26 percent of worldwide prescription drug sales.[7]

Valuation Approaches

There are four different types of valuation methods that can be used to value pharmaceutical companies, as follows:

  1. Asset-based valuation: This method calculates a business’s equity value as the fair market value of a company’s assets less the fair market value of its liabilities. This approach is also sometimes referred to as a “cost-based approach”; that is, the business’s value is equal to the cost of acquiring its physical assets. This approach is seldom used for a pharmaceutical company because its value is more closely related to intangible assets, R&D expenditure, and cash flows.
  2. Income approach (capitalization of earnings): This method is most applicable to companies that face predictable and constant growth in earnings and have an established record of operations.  The business value under this method is equal to the cash flow projection for the next year divided by a capitalization rate (i.e. the appropriate discount rate less the predicted growth rate).
  3. Income approach (discounted cash flow): The value of equity utilizing this method is equal to the present value of free cash flows available to common equity holders over the life of the business. This method works well for both established companies with low growth rates as well as new companies with higher rates of growth, and requires forecasting future cash flows.
  4. Market approach: This method utilizes market indications of value based on metrics from guideline publicly traded pharmaceutical companies or privately held businesses. The financial metrics of public companies or those of private transactions, such as P/E, P/S, and EV/EBITDA, can be used to generate valuation multiples that are then used to calculate business value.

Key Performance Metrics

The following are performance metrics that managers in the pharmaceutical industry may use to benchmark their performance against others in the industry:

  1. Sales
  2. Operating Profit Margin
  3. R&D spending as percentage of sales
  4. Core earnings per share
  5. Operating free cash flow as percentage of sales</