Measuring life cycles using binomial option pricing: The pharmaceutical industry

• DOI: http://doi.org/10.1002/jcaf.22391
• Published date: 01 July 2019
• Date: 01 July 2019

BLIND PEER REVIEW

Measuring life cycles using binomial option pricing: The

pharmaceutical industry

Nancy Beneda

Department of Economics and Finance,

University of North Dakota, Grand Forks,

North Dakota

Correspondence

Nancy Beneda, Department of Economics

and Finance, University of North Dakota,

Centennial Dr., Grand Forks, ND 58202.

Email: nancy.beneda@und.edu

Abstract

This study examines the Ncomputed using an American Binomial Option Pricing

Model to address issues in evaluating firms which may be difficult to value such as

new pharmaceutical firms. New pharmaceutical products can take up to 12 years to

bring a new product to market. This study uses a sample of 15 pharmaceutical ini-

tial public offerings (IPOs) brought to market in 2,000. The current study uses a

firm's excess market value as a measure of valuable growth opportunities. The

study attempts to estimate how much remaining investment in research and devel-

opment (R&D) is required for potential market success. The study solves for Nin

an American Binomial Option Pricing Model. The resulting Nrepresents a number

which when multiplied by R&D, results in an implied estimated amount of

remaining investment in R&D, which the stock market has priced into the value of

growth opportunities. The option valuation model uses the firm's excess market

value as a call option on the firm's market value, and R&D times N, as the strike

price. Nis computed for each firm and year observation. The results of the current

study suggest that the N, computed in the option-pricing model, is negatively and

highly associated with a firm's future performance and future productivity of

investment in R&D.

KEYWORDS

binomial modeling, life cycles, pharmaceutical firms

1|INTRODUCTION AND

LITERATURE REVIEW

To address some of the issues related to evaluating new start-

ups, the current study focuses on new pharmaceutical initial

public offerings (IPOs) and examines indicators of future per-

formance and future productivity of investment in research

and development (R&D). Investing in new pharmaceutical

companies is often considered as expl oring unchartered terri-

tories, primarily because the majority of new pharmaceutical

firms have negative earnings and some have no revenues.

Examining start-up companies has been an important topic

in the literature because of the challenges faced in forecasting

future performance and growth. Many young companies may

have negative earnings and/or no revenues. And the available

information is very noisy, if existent.Valuations based on dis-

counting future cash flows are difficult. Baum and Silverman

(2004) suggestthat when straight-forwardand transparent tech-

niques for ascertaining the success of a bio-pharmaceutical

startup are not available, other methodologies must be used by

venture capitalists. Damodaran(2009) examines the challenges

faced when valuing young companies, including startups

and IPOs.

Other than capital funding cycles (Brown, Fazzari, &

Petersen, 2009; Li, 2011; Nanda & Rhodes-Kropf, 2013) and

industry differences (Garci-Manj'on& Romero-Merino, 2012)

Received: 22 February 2019 Revised: 28 March 2019 Accepted: 3 April 2019

DOI: 10.1002/jcaf.22391

20 © 2019 Wiley Periodicals, Inc. J Corp Acct Fin. 2019;30:20–29.wileyonlinelibrary.com/journal/jcaf