Measuring life cycles using binomial option pricing: The pharmaceutical industry

Published date01 July 2019
Date01 July 2019
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
Nancy Beneda, Department of Economics
and Finance, University of North Dakota,
Centennial Dr., Grand Forks, ND 58202.
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.
binomial modeling, life cycles, pharmaceutical firms
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;

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