Valuation of Medical Innovation in Orphan Diseases with a Focus on Small Investors and Limited Diversifiable Risks

This paper assesses the impact of uncertainty for investors on the economic valuation of medical innovation projects for orphan drugs or rare diseases. Conventionally, investor evaluation uses the deterministic discounted cash flow (DCF) method with an appropriate sensitivity analysis that captures some level of uncertainty. In healthcare, and particularly for rare diseases, the levels of uncertainty in financial outcomes (return on investment and net present value (NPV)) are broader than the ones normally captured by the DCF formula. Uncertainties include R&D costs, the approval process (level and timing) for obtaining reimbursement, sales, the production cost, and the failure probabilities of the clinical trial phases, to name a few. Additionally, there is not only one type of investor to consider, but different investors exposed to different levels of risk management of their investment. Our analysis tried to capture those two dilemmas (higher levels of uncertainty and different investor types) in two ways. One way was to identify a better method to enhance the different levels of uncertainty. The real option method of evaluation was proposed instead of DCF. For instance, the real option method better captures the uncertainty of the different phases of product development. The other way is to differentiate the investor types through their level of risk assessment perspectives. Small investors and start-up companies may see more benefit in applying the real option methodology to estimate their NPVs at different time points during product development. In summary, our evaluation identified various types of uncertainty when assessing an investment, along with methods to manage their effect on the economic/financial outcomes of medical innovations. Given the high uncertainty associated with early-stage drug development, such as orphan drugs for rare diseases, the real options approach is preferable to traditional DCF models. The analysis also showed that there is not just a single investor perspective to consider but specific perspectives that enhance the prime use of the real option methodology.