Key Financial Ratios to Analyze Biotech Companies

Among the key financial ratios market analysts and investors use to evaluate companies in the biotechnology industry are the return on research capital (RORC) ratio, the price/earnings-to-growth (PEG) ratio, and the quick ratio.

The biotechnology industry is engaged in the development and marketing of biological organisms used in products or processes. More than half of biotechnology revenues come from the field of medicine, where biotechnology has been increasingly used to develop new methods and products for the treatment of diseases. The industry is also widely active in the fields of biofuels, waste treatment, and food production.

Since its advent in the 1980s with pioneering companies such as Amgen Inc. (Nasdaq: AMGN), the biotechnology industry has grown rapidly and at an accelerating pace. Industry revenue increases have been driven in large part by increases in the use of ethanol; breakthroughs in gene therapy and other medical treatments; and a push for higher crop yields to feed an ever-growing world population. A trend in the industry is consolidation, primarily through mergers and acquisitions (M&As) in the pharmaceutical industry. The industry is projected to experience increasing growth and revenues, assisted by government funding of research and by the ongoing healthcare needs of an aging baby-boom population.

For investors, the industry has produced such notably profitable stocks as Gilead Sciences (Nasdaq: GILD), Celgene Corporation (Nasdaq: CELG) and Biogen (Nasdaq: BIIB). Good analysis of biotech companies is critical for investors because of the highly competitive nature of the industry. There are more than 1,000 biotech companies just in the United States. Key areas for analysis include research and development (R&D), expenditures, revenue growth, and general financial and coverage ratios.

The biotechnology industry expends large amounts of capital on R&D. Therefore, an important point for analysis of biotech companies is the return companies generate from such major capital expenditures. The RORC ratio, or RORC, is one of the primary equity metrics used for this purpose. The ratio is calculated by dividing the current year's gross profit by the previous year's R&D expenditures, thereby showing from one year to the next the impact on revenue and profitability resulting from R&D expenses. The ratio is considered not only indicative of return on invested capital (ROIC) but also a general metric of growth and productivity. Since average returns vary widely between and even within industries, it is important to compare the RORC metric of similar companies engaged in the same primary business or producing similar products.

The PEG ratio is a popular variation of the price-to-earnings (P/E) ratio. It is considered well-suited for evaluation of biotech companies because growth rates are an important factor in analyzing biotech stocks. The PEG ratio is calculated by dividing a company's P/E ratio by its annual growth in earnings per share (EPS). It is considered by many analysts to provide a more complete assessment of a company's value than the traditional P/E ratio. While the ratio varies by industry, generally speaking, a PEG ratio of 1 indicates a stock is fairly valued. A PEG ratio lower than 1 may indicate an undervalued stock, while ratios higher than 1 may mean the stock is currently overpriced. As with the P/E ratio, analysts sometimes use trailing EPS figures and forward projected EPS numbers in the calculation.

The quick ratio is a basic equity evaluation metric of cash flow and liquidity. It indicates a company's ability to meet all of its outstanding short-term obligations with liquid assets, defined as cash or quick assets. Quick assets are those that can be quickly converted to cash for amounts relatively close to their current book value. The quick ratio is calculated as current assets minus inventory, divided by short-term obligations. This ratio is used as a basic indicator of a company's current financial health. It is important for evaluating biotech companies because of the long lag time between new product development and going to market, during which companies must be able to sustain themselves with current revenues and assets. Higher quick ratios are better, and ratios less than 1 are unfavorable.