In a recent WashingtonMonthly post I’m once again seeing people who don’t understand why pharmaceutical companies need to earn more profit than average companies in order to attract investment. As a service I thought I would offer a quick illustration of why they need to. The non-math answer is that pharmaceutical companies are riskier (lots of them go out business providing a -100% return to their investors. Those that don’t go out of business lose and gain money at wild intervals. Investors can invest in other things and have lower amounts of risk. This risk has to be compensated by higher up-side returns. For those not math-phobic lets look at that a little more closely.
For purposes of this example we will say that you invest for exactly one year and have exactly $1,000. We will assume the money is not capitalized at intervals during the year.
Investment Option 1
Government Bonds. It is very safe, with a lowish formal rate for a low return.
Lets say you can get a 1 year T-bill at 5.0%.
Your expected return is
That is $1,050 for an expected 5% return on your money.
Investment Option 2
McDonalds Franchise. Pretty safe with some chance of breaking even and some chance of losing everything.
Lets say you get a 95% chance of getting a 13.7% rate, a 3% chance of breaking even and a 2% chance of losing everything. If you don’t know which franchises are going to be the failures your expected return is .95(1,000+1,000[.137])+0.03(1,000)+.02(0).
That is $1,110.15 for an expected 11% return on your money. We will round that to $1,110.
Investment Option 3
Lets say we don’t know anything about it other than the risk profile. The risk profile is somewhat worse than McDonalds but not crazy (risk of losing money is 10% or less). The exact profile is a 90% chance of getting the up-side return (‘X’) a 5% chance of losing 10% of the value and a 5% chance of losing everything. The formula to find out what the up-side rate would have to be to break even with McDonalds is
Solving for X we find that the rate to break even with McDonalds is .1833 or 18.33%.
What would happen if we gave Investment Option 3 a McDonalds level upside return?
Your expected return if you didn’t know which ones would lose money would be .9(1,000+1,000[.137]])+.05(1,000-1,000[0.1])+.05(0)=$1,068.3 for an expected 6.8% return. This is very close to the return rate on the government bonds (which are theoretically 100% safe).
So in order to have an expected ending value equal to the McDonalds investment you would need to earn 18.33% on the up side of the riskier investment compared to the 13.7% rate of the McDonalds investment. Of course you would be a fool to make the investment at only 18.33% because your chance of losing money is greater in the risky investment while your expected value is the same. So you need to earn even more if you are going to bother with the riskier investment. Now I don’t know exactly what McDonalds investment returns are, but I did set it up so that Investment Option 2 tracks the average annual return of the general US stock market, 11%. Pharmaceutical companies are much riskier than the general US stock market, so they need much higher returns on the upside to make the risk worthwhile.
Sorry about the font weirdness, I performed a cut and paste from word and apparently that didn't work well. I don't have time to fix it right now.