Most debates in the US over the cost of drug development, drug prices or industry profits involve the risk associated with pharmaceutical and biotech R&D. Many view the pharmaceutical and biotech industries as one industry, with the same risks and effects of government regulation. This article illustrates the significant differences between biotech and pharmaceutical firms in the US with respect to firm characteristics, financial risk and regulatory policy sensitivity.
Financial risk is important to pharmaceutical and biotech firms because it determines the returns that investors require to fund their R&D spending: the more risk, the more return that investors require. One can consider a firm's financial risk in two general ways. First, accounting figures reported by firms in their financial statements can be used to illustrate their financial fragility. Second, a firm's stock return data can be applied to models of systematic financial risks to estimate the levels and types of systematic risks to which a firm is sensitive. Systematic financial risks cannot be diversified away; hence, investors require greater rates of return from the securities of firms with higher levels of systematic risk.
The returns that investors require from firms to fund their R&D investment are important because a firm's cost of capital is the largest component of the cost of developing a new medicine. DiMasi et al. showed that it accounts for about 50% of total R&D costs. Substantial capital costs accumulate over the 15 years that it takes on average to develop a new medicine. When the costs of funding R&D for a new medicine are large, firms will not invest in R&D unless the expected profits of a new medicine are also large (often requiring high prices).
To date, the relatively young biotech industry has not been studied as much as the pharmaceutical industry, at least with respect to financial risk and R&D spending decisions. These two industries have important structural and financial differences; yet they are often lumped together and treated as one in debates and policy formulation. Indeed, while they do share many similarities, they also differ in important ways. For example, it is often much more costly to manufacture each dose of a bio-engineered medicine than a typical chemical-based pharmaceutical.
Most large pharmaceutical companies finance their R&D projects with cash flows generated from existing product sales. In contrast, many biotech firms rely on external stock financing to fund their R&D projects.[2-4] Recognizing the biotech industry's unique characteristics is especially important when assessing the differential impact of government regulations on biotech compared with pharmaceutical firms. For example, Reed et al. suggested that recent regulations being considered by the US FDA could be more costly for biotech firms than pharmaceutical firms, leading them to reduce R&D.
The pharmaceutical industry makes a good benchmark for comparison because it is a major competitor-partner to the biotech industry and because other relatively R&D-intensive industries are much different (the computer software industry is the third most R&D intensive after the biotech and pharmaceutical industries). The average R&D intensities (R&D spending divided by total firm assets) for the biotech and pharmaceutical industries over the last 25 years were 38% and 25%, respectively, compared with about 13% for the computer software industry.
The objective of this article is to illustrate the differences between the biotech and pharmaceutical industries using graphical analysis and statistical measures of the differences in financial risks.
1. Data Sample and Financial Comparisons
To be included in the sample, a firm must have been publicly traded and had data available on both the Compustat and Center for Research in Securities Prices (CRSP) databases. …