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The key to the analysis of pharmaceutical companies is understanding the pipeline of new products. Long term growth is driven by new treatments. At the other end of a drug's cycle, the profitability of drugs declines sharply when patents expire and generic versions are launched. Although out of patent drugs bring in some money, prices are lower, so both revenue and margins are much lower: profits almost always insignificant, except for specialists in generic drugs.

This means that the usual measures like the PE ratio need to be used more cautiously. Things can change very fast. The big pharmaceutical companies are better diversified, but even they can see significant changes to profits when a blockbuster drug is launched or key patents expire.

Valuing a drug pipeline

Analysing the pipeline requires assessing:

• the size of the market for each product,
• market share, pricing and margins, and,
• the risk that regulators will not approve it.

The last is usually difficult because clinical trails are not complete, and it is impossible to predict what may be discovered. All one can do is keep an eye on any announcements about key drugs.

The market size is most often straightforward. It is not very difficult to find out how many people suffer from a given condition in the major markets for pharmaceuticals: the US, the EU and Japan. It is something that changes over the long term, for example, the current increase in age related conditions as populations age. There can also be somewhat more rapid changes as medical opinions change: the increase in treated cases of ADHD is a good example of this.

A company's current strength in a market can be be one indicator of likely market share. This is especially true for new drugs that aim to replace the sales of a similar one that is going off-patent. Sometimes these are merely improved reformulations containing the same active ingredient.

For completely new drugs it is worth looking for a wide range of indications of its potential. The price of existing treatments, whether patients will like the new drug, whether doctors show interest in prescribing it — talking to doctors and nurses about the pros and cons of anything really novel can give one a lot of insights. Given the long term nature of the pipeline, the aim of all this will often be to calculate an NPV. If a valuation ratio is used, it is best to look many years forward.

Sales forces matter

The ability to sell a particular drug is also a key issue. The major pharmaceutical companies have huge global sales forces. Mid-size pharmas tend to specialise in a particular area, and employ a sale force large enough to reach one type of specialist. These and smaller companies also often license drugs out, either globally, or in particular markets where they can find a partner with a better sales force.

In some ways sales and marketing is even more important to pharmaceutical companies than R & D. A major pharma can license-in drugs to fill gaps in its pipeline. It cannot, so easily, compensate for any deficiencies in its sales force. This is why they spend as much on their sales forces as on research(although their PR tends to stress the latter). As investors, we still need to concentrate on the drugs pipeline because that is where the uncertainties are.

Biotechnology and vaccines

Although we have so far only talked about drugs pharmaceutical companies also have other types of product. The most important of these are biotechnology products and vaccines. Vaccines differ from drugs in one very important (to investors) way: the major barrier to entry is not patents, but regulatory approval, which is far more complex and cannot be shortened by showing. This effectively keeps generics manufacturers out and makes patent expiries less significant.

Analysing the financials

You may by now be wondering how the usual numbers investors look at are applied to pharmaceutical companies. The answer is, simply, largely in the same way as as other companies. It is usually a cash generative business, so measures of financial strength are usually of secondary importance, except for start-ups that need to have a sufficient cash pile to see them through to profitability. Look at the balance sheet, if only to look for hidden nasties. You need to look at everything, but, you will usually find that matters most is the pipeline and patent expiries.