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Few things get a retail investor’s blood pumping more than the risk/reward prospects in the biotech sector.  New drugs mean the potential for big profits.  If an experimental treatment receives commercial approval, the share price skyrockets.  Unfortunately, the opposite is also true.  If clinical trials are delayed or fail, share price plummets in a heartbeat.

As an example, look at this 1-year chart for Australian biotech Tissue Therapies Limited (TIS):

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In the fall of 2010, the company announced positive results from a clinical study of its VitroGro product and shortly thereafter released the news the product had been granted a patent in the United States.  The potential rewards are obvious.  Had the trials failed and the patent been denied, the risks would have appeared equally obvious.

In short, investing in the biotech sector is not for the faint of heart.  However, because the reward potential is so significant, even some risk-averse investors start salivating when they learn of some tiny biotech company out there with the next break though drug in their product pipeline.  If you are unfamiliar with the biotech industry, one of the first things to learn is that drug stgelopment is a lengthy and costly process.  During the stgelopment process, companies hemorrhage money and it can take years before they take in a dime from the first sale.

Last week in the Sector Scan column here on thebull.com.au, Patersons Securities analyst James Georges shared his view that the emerging global economic recovery should spur future growth in biotech, a sector that has seen a slowdown in recent years.

He gave us a list of six shares to consider, highlighting Sirtex Medical (SRX) as the company with the most attractive growth prospects, adding the caution about the risk involved in the sector.  He also pointed to CSL Limited as one of Australia’s best businesses, so we will use CSL as a comparison company to evaluate SRX – by the numbers.

Profitability Ratios/Dividends

 SRXCSL
ROE (Return on Equity)3122.1
ROA (Return on Assets)31.220
Dividend Yield1.32.4

 

These two ratios show how effective a company is at translating assets or shareholder equity into profitable income. Both companies display above average returns on these measures.  However, SRX is plainly more profitable than CSL. An ROE above 15% and an ROA above 5% are indicators of a good return on your investment dollar.

Intelligent investors know the Dividend Yield does more than put a little money into your pocket.  It also serves as an indicator of management confidence in the company’s performance.  No company issues a dividend if they suspect profitability might decline in the future.  CSL returns a slightly higher dividend to its investors than does SRX.

Liquidity and Debt

Liquidity Ratios measure a company’s ability to convert assets into cash should the need arise.  In most cases, debt is the reason.  If you see shares with low liquidity ratios – especially those below 1 – and high debt, you have cause for concern.  Why?

This is a good question since liquidity ratios measure ability to handle short-term liabilities.  In theory, this means the portion of a company’s debt that is long term – not payable in the current fiscal year – should not matter.  In practice, when times get tough, long term debt holders can “call the debt,” depending on the structure of the debt instruments.  This is what happened to American investment bank Lehman brothers.  As they descended deeper and deeper into the pit, some of their debt-holders exercised their rights to accelerate repayment.  Here are the numbers for SRX compared to CSL.

 SRXCSLSector
Current Ratio44.244.3
Quick Ratio3.862.363.8
Total Debt0462mN/A

 

Both companies are very liquid.  A ratio of 4 means the company could meet its current short-term obligations four times over.  However, the stunning number here is Total Debt, and no, that is not a typo in the SRX column.  They do not owe anybody anything. 

Market Valuation Ratios

Market valuation ratios are the favored analytical tool of many investors because they use a real value that cannot be manipulated – the market price per share.  All these ratios use the price market participants are willing to pay compared to other company indicators – earnings per share, expected growth, book value, and total sales.  Here are the numbers:

 SRXCSLSector
Price to Earnings (P/E)25.3119.214.8
Price to Earnings Growth (PEG)102.0610
Price to Book (P/B)5.654.422.03
Price to Sales (P/S)4.512.248.57

 

The P/E ratio for SRX tells us the market sees this company as a growth share.  While value-oriented investors would say it is overpriced, the fact is, there are sufficient market participants willing to pay more for these shares.  Their Price to Book is also higher than the sector average, again indicating the willingness of market participants to pay a higher price for the shares than its raw fundamentals might warrant.

Although the PEG ratio for SRX is quite high, it is right in line with the sector average.  High PEGs are indicators of a potentially overvalued share.  

The numbers here tell a clear story.  The market is expecting high growth from Sirtex Medical and is willing to pay a premium price for the privilege of going along for the upward ride.

Year over Year Performance

Restricting a by the numbers share analysis to sector performance and that of a competitor always suffers from the downside of comparing apples to oranges.  Although both SRX and CSL are biotech companies, their products are not the same.  

Any effort at a quantitative analysis of a share should include a comparison of the company’s performance on certain measures against itself.  Here are some comparisons between SRX performance for fiscal year 2010 versus FY2009:

 20102009
Revenue64.3m65.5m
Net Profit after Taxes (NPAT)16.1m18.2m
Earnings per Share (EPS)28.832.7
Dividends per Share (DPS)    7c0

 

As you can see, SRX did not have a growth year.  The only thing positive here is DPS – while they paid no dividend in 2009, the company was confident enough to declare a small dividend of 7 cents per share.  On every other measure, performance declined in 2010.

What happened?  How can a company -perceived by market participants as having growth potential show these declines?  For that question, we will have to look behind the numbers.

Please note that TheBull.com.au simply publishes broker recommendations on this page. The publication of these recommendations does not in any way constitute a recommendation on the part of TheBull.com.au.You should seek professional advice before making any investment decisions.