PHARMACEUTICAL DEVELOPMENT PROJECT
Using Monte Carlo simulation in the drug development industry
The nature of a drug development project is characterized by high attrition rates, large capital expenditures, and long timelines. This makes the valuation of such projects and companies a challenging task. Not all valuation methods can cope with these particularities. Some of the most commonly used valuation methods are risk-adjusted net present value (rNPV) and decision trees.
Risk-adjusted net present value (rNPV) or eNPV (expected NPV) is a method to value risky future cash flows in the pharmaceutical industry. However, we propose here a methodology that vastly overcomes the inherent flaws of making decisions “on the average”, which is what rNPV does.
The rNPV methodology modifies the standard NPV calculation of discounted cash flow (DCF) analysis by adjusting (multiplying) each cash flow by the estimated probability of success (the estimated success rate). In the language of probability theory, the rNPV is the expected value. rNPV is the standard valuation method in the drug development industry, where sufficient data exists to estimate success rates for all R&D phases.