What makes the modeling and valuation of pharmaceutical companies special? Firstly, there's research and development.
Typically, pharmaceutical companies will spend a substantial amount of money on research and development expenditure in the hope of discovering and developing new products.
The main reason that this is such a strong incentive for pharmaceutical companies is the prospect of a 20 year patent on a newly discovered drug.
This monopoly position will enable that pharmaceutical company to generate substantial profits on that new drug until other competitors are able to enter the market.
However, that does not last for the full 20 year period.
The clock on the 20 year period starts running from the date when the company files for the patent.
That is often well before the product will be made available to the general public, so there may be even less than 10 years when the company can actually generate those monopoly profits.
These r and d costs may initially be recognized either in the income statement or the balance sheet, depending on the applicable accounting rules.
Uncertainty. The success of pipeline drugs is highly uncertain, as there are many rounds of clinical trials that a new drug has to get through before it can be made available for sale to the general public.
As a result in trying to forecast revenues for pharmaceutical companies, it is often necessary to do this on a product by product basis, both for products that are already on sale because they may be reaching the end of their patent period, or alternatively for new products which may not reach the market if they don't achieve success at the necessary clinical trials.
Collaboration, often due to the high costs of developing a new drug, it may not be possible for the company which has developed the drug to spend even more money developing the facilities for the manufacturer and the distribution of that drug.
It may well be the case that the discoverer of the drug who holds the patent may get involved in a joint venture with a larger, more established pharmaceutical company to facilitate as wide a possible manufacture and distribution of a new drug.
Finally, tax breaks to encourage the social benefit of the discovery of new drugs.
It is often the case that the r and d spending may be treated as a tax credit resulting in lower tax bills for companies such as pharmaceutical companies spending lots of money on r and d.
As a result, you may well find for a pharmaceutical company that their effective tax rate, the tax expense divided by the profit before tax on the face of the income statement is substantially lower than the statutory tax rates in that country.
