The valuation of a NDA using a 6-fold compound option

This paper presents anew methodology for valuing new drug applications (NDA) and the R&D of pharmaceutical companies based on real option models. Traditional valuation models fail to capture the full value created by R&D to pharmaceutical companies, because they do not correctly model the nature of the process of developing a new drug. It is a series of consecutive phases from R&D to commercialisation, where each phase is in fact an option on executing the following phase, i.e. a compound option. For a NDA, the R&D phase can best be presented as a 6-fold compound option on the commercialisation phase. Using a generalisation of Geske's compound option model, we derive a closed-form solution for a n-fold compound option model, and apply it to calculate the value of a NDA using sector average figures. (C) 2003 Elsevier B.V. All rights reserved.