Take the 2-minute tour ×
Personal Finance & Money Stack Exchange is a question and answer site for people who want to be financially literate. It's 100% free, no registration required.

I'm looking at this link, which lists P/E ratios by industry. I see that biotechnology has a P/E ratio of 145, which is very high compared to other industries. What is so special about this industry that results in such a high P/E ratio?

I understand that the P/E of a particular company can be high related to its industry. But how can a whole industry be out of line with the other industries?

share|improve this question
3  
Generally bio-tech is the "industry of the future" for about a decade now since the dot-com bubble. I'm not sure if it explains it, but that's my take on it. –  littleadv Jan 22 '13 at 18:49

3 Answers 3

up vote 5 down vote accepted

If you look at the biotech breakdown, you'll find a lot of NAs when it comes to P/E since there are many young biotech companies that have yet to make a profit. Thus, there may be something to be said for how is the entire industry stat computed.

Biotechnology can include pharmaceutical companies that can have big profits due to patents on drugs.

As an example, look at Shire PLC which has a P/E of 1243 which is pretty high with a Market Capitalization of over a billion dollars, so this isn't a small company. I wonder what dot-com companies would have looked like in 1998/1999 that could well be similar as some industries will have bubbles you do realize, right?


The reason for pointing out the Market Capitalization is that this a way to measure the size of a company, as this is merely the sum of all the stock of the company. There could be small companies that have low market capitalizations that could have high P/Es as they are relatively young and could be believed to have enough hype that there is a great deal of confidence in the stock. For example, Amazon.com was public for years before turning a profit. In being without profits, there is no P/E and thus it is worth understanding the limitations of a P/E as the computation just takes the previous year's earnings for a company divided by the current stock price. If the expected growth rate is high enough this can be a way to justify a high P/E for a stock. The question you asked about an industry having this is the derivation from a set of stocks. If most of the stocks are high enough, then whatever mean or median one wants to use as the "industry average" will come from that.

share|improve this answer
    
Thanks. In addition to P/E , why we need to look at market cap to get a truer picture? can you kindly explain? –  Victor123 Jan 23 '13 at 17:16

I want to elaborate on some of the general points made in the other answers, since there is a lot that is special or unique to the biotech industry. By definition, a high P/E ratio for an industry can stem from 1) high prices/demand for companies in the industry, and/or 2) low earnings in the industry. On average, the biotech industry exhibits both high demand (and therefore high prices) and low earnings, hence its average P/E ratio. My answer is somewhat US-specific (mainly the parts about the FDA) but the rest of the information is relevant elsewhere.

Short answer

The biotech industry is a high-priced industry because for several reasons, some investors consider it an industry with significant growth potential. Also, bringing a drug to market requires a great deal of investment over several years, at minimum. A new drug may turn out to be highly profitable in the future, but the earliest the company could begin earning this profit is after the drug nears completion of Phase III clinical trials and passes the FDA approval process.

Young, small-cap biotech companies may therefore have low or negative earnings for extended periods because they face high R&D costs throughout the lengthy process of bringing their first drug (or later drugs) to market. This process can be on the order of decades. These depressed earnings, along with high demand for the companies, either through early investors, mergers and acquisitions, etc. can lead to high P/E ratios.

Long answer

High prices/demand

I addressed in detail several of the reasons why biotech companies are in demand now in another answer, but I want to add some information about the role of venture capital in the biotech industry that doesn't necessarily fit into the other answer.

Venture capital is most prevalent in tech industries because of their high upfront capital requirements, and it's even more important for young biotech companies because they require sophisticated computing and laboratory equipment and highly-trained staff before they can even begin their research. These capital requirement are only expected to rise as subfields like genetic engineering become more widespread in the industry; when half the staff of a young company have PhD's in bioinformatics and they need high-end computing power to evaluate their models, you can see why the initial costs can be quite high.

To put this in perspective, in 2010, "venture capitalists invested approximately $22 billion into nearly 2,749 companies." That comes out to roughly $7.8M per company. The same year (I've lost the article that mentioned this, unfortunately), the average venture capital investment in the biotech industry was almost double that, at $15M. Since many years can elapse between initial investment in a biotech company and the earliest potential for earnings, these companies may require large amounts of early investment to get them through this period.

Low earnings

It's also important to understand why the biotech industry, as a whole, may exhibit low earnings for a long period after the initial investment. Much of this has to do with the drug development process and the phases of clinical trials. The biotech industry isn't 100% dedicated to pharmaceutical development, but the overlap is so significant that the following information is more than applicable.

Drug development usually goes through three phases:

  1. Drug discovery - This is the first research stage, where companies look for new chemical compounds that might have pharmaceutical applications. Compounds that pass this stage are those that are found to be effective against some biological target, although their effects on humans may not be known.

  2. Pre-clinical testing - In this stage, the company tests the drug for toxicity to major organs and potential side effects on other parts of the body. Through laboratory and animal testing, the company determines that the drug, in certain doses, is likely safe for use in humans. Once a drug passes the tests in this stage, the company submits an Investigational New Drug (IND) application to the FDA. This application contains results from the animal/laboratory tests, details of the manufacturing process, and detailed proposals for human clinical trials should the FDA approve the company's IND application.

  3. Clinical trials - If the FDA approves the IND application, the company moves forward with clinical trials in human, which are themselves divided into several stages.

    • Phase I - In this phase, the drug is tested in humans to fully determine the proper dosage and to confirm its safety for widespread testing.
    • Phase II - This phase involves testing the drug in a larger group of people to better determine its efficacy. This also allows the company to test its safety in a similar fashion to the testing done in Phase I but on a larger scale. Much of the failure in drug development occurs in this phase when a drug is found not to work as well as expected or to have potentially toxic side effects.
    • Phase III - This is the final phase before the drug is submitted for FDA approval; it usually involves large-scale testing in randomized, double-blind studies with thousands of patients at multiple clinical sites. In some cases, a company may continue Phase II testing with certain forms of a drug while moving on to Phase III testing with other variations of the compound. Once Phase III has been completed or has yielded significant positive results, or enough ongoing studies have shown promise, the company compiles a New Drug Application and submits it to the FDA for approval.
  4. "Post-clinical phase" / ongoing trials - This stage is sometimes considered Phase IV of the clinical trials stage. Once the drug has been approved by the FDA or other regulatory agency, the company can ramp up its marketing efforts to physicians and consumers. The company will likely continue conducting clinical trials, as well as monitoring data on the widespread use of the drug, to both watch for unforeseen side effects or opportunities for off-label use.

I included such detailed information on the drug development process because it's vitally important to realize that each and every step in this process has a cost, both in time and money. Most biopharm companies won't begin to realize profits from a successful drug until near the end of Phase III clinical trials. The vast R&D costs, in both time and money, required to bring an effective drug through all of these steps and into the marketplace can easily depress earnings for many years.

Also, keep in mind that most of the compounds identified in the drug discovery stage won't become profitable pharmaceutical products. A company may identify 5,000 compounds that show promise in the drug discovery stage. On average, less than ten of these compounds will qualify for human tests. These ten drugs may start human trials, but only around 20% of them will actually pass Phase III clinical trials and be submitted for FDA approval.

The pre-clinical testing stage alone takes an average of 10 years to complete for a single drug. All this time, the company isn't earning profit on that drug. The linked article also goes into detail about recruitment delays in human trials, scheduling problems, and attrition rates for each phase of the drug development process. All of these items add both temporal and financial costs to the process and have the potential to further depress earnings.

And finally, a drug could be withdrawn from the market even after it passes the drug development process. When this occurs, however, it's usually the fault of the company for poor trial design or suppression of data (as in the case of Vioxx).

Caution

I want to make one final point to keep in mind when looking at financial statistics like the P/E ratio, as well as performance and risk metrics. Different biotech funds don't necessarily represent the industry in the same way, since not all of these funds invest in the same firms. For example, the manager of Fidelity's Select Biotechnology Portfolio (FBIOX) has stated that he prefers to weight his fund towards medium to large cap companies that already have established cash flows. Like all biopharm companies, these firms face the R&D costs associated with the drug development process, but the cost to their bottom line isn't as steep because they already have existing cash flows to sustain their business and accumulated human capital that should (ideally) make the development process more efficient for newer drugs.

You can also see differences in composition between funds with similar strategies. The ishares Nasdaq Biotech Index Fund (IBB) also contains medium to large cap companies, but the composition of its top 10 holdings is slightly different from that of FBIOX. These differences can affect any metric (although some might not be present for FBIOX, since it's a mutual fund) as well as performance.

For example, FBIOX includes Ironwood Pharmaceuticals (IRWD) in its top 10 holdings, while IBB doesn't. Although IBB does include IRWD because it's a major NASDAQ biotech stock, the difference in holdings is important for an industry where investors' perception of a stock can hinge on a single drug approval. This is a factor even for established companies.

In general, I want to emphasize that a) funds that invest more heavily in small-cap biotech stocks may exhibit higher P/E ratios for the reasons stated above, and b) even funds with similar mixes of stocks may have somewhat different performance because of the nature of risk in the biotech industry. There are also funds like Vanguard's Healthcare ETF (VHT) that have significant exposure to the biotech industry, including small-cap firms, but also to major players in the pharmaceutical market like Pfizer, Johnson and Johnson, etc. Since buyouts of small-cap companies by large players are a major factor in the biotech industry, these funds may exhibit different financial statistics because they reflect both the high prices/low earnings of young companies and the more standard prices/established earnings of larger companies.

Disclaimer:

Don't interpret anything I stated above as investment advice; I don't want anything I say to be construed as any form of investment recommendation, since I'm not making one.

share|improve this answer
    
Upon rereading this Q&A I see you've expanded nicely on my high level answer above. Nice work. +1 –  JoeTaxpayer Jun 5 '13 at 13:00

Residential Construction at 362x, by the way.

I'm going to hazard a guess here - Say XYZ corp trades at $100, and it's showing a normal earnings of $10 the last few years. Its industry falls on hard times, and while it makes enough to keep its doors open, profits fall to $1. The company itself is still sound, but the small earnings result in a high P/E. By the way, its book value is $110, and they have huge cash on the books along with real estate.

I offer these details to show why the price doesn't drop like a rock.

Now, biotech may be in a period of low reported earnings but with future results expected to justify the price. On one hand it may be an anomaly, with earnings due to rise, or it may be a bit of a bubble. An analyst for this sector should be able to comment if I'm on the right track.

share|improve this answer

Your Answer

 
discard

By posting your answer, you agree to the privacy policy and terms of service.

Not the answer you're looking for? Browse other questions tagged or ask your own question.