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How to Value a Business Based on Future Earnings

When valuing a business, it’s crucial to focus on future earnings rather than current or past performance. Future earnings provide a more accurate reflection of a company’s potential for growth and profitability. In this newsletter, we’ll explore how to invest in a business based on its future earnings, using Innoviva as a case study on how to value a company.

Hello and welcome to this week’s Lockstep Investing Newsletter.

I’m excited about this week’s edition as we discuss the following:

  • How to Value a Business Based on Future Earnings: When valuing a business, it’s crucial to focus on future earnings rather than current or past performance. We’ll explore how to invest in a business based on its future earnings, using Innoviva as a case study on how to value a company.

  • Lesson Learned: Peter Lynch provides us with more sage advice, cutting to the core of investment success.

Ready?

Let’s dive in!

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MARKET RECAP

Market Performance - Week 22

Economic News

Inflation As Expected

The week’s highlight was April’s Personal Consumption Expenditure (PCE) Price Index, published on Friday.

The PCE Price Index, the Federal Reserve’s preferred measure of inflation, increased by 2.7% year-over-year (YoY), aligning with expectations. The market and the Fed are concerned about rising inflation, as the index increased from 2.5% in January to 2.7% in March. Therefore, this reading provided some relief.

The Federal Reserve forecasts a December 2024 PCE of 2.4%. While this is close to the current level, the market wants inflation to trend downwards to meet the Fed’s target. If the Fed is satisfied that inflation is under control, the likelihood of a rate cut will increase.

Mixed Economic Data

Other economic data from last week came in mixed;

On Tuesday, May’s US Consumer Confidence Report was published, showing that the Consumer Confidence Index rose from 97.5 in April to 102 in May, indicating improving consumer expectations of the economy.

On Wednesday, the Fed’s Beige Book, a summary of the economy published before the Fed’s interest rate deliberations, pointed to continued economic expansion, reinforcing the narrative of a robust economy.

However, on Thursday, the US Q1 2024 GDP was adjusted from 1.6% to 1.3%. Gross Domestic Product (GDP) measures a country’s economic activity, so a downward revision implies the economy did not grow as much as initially expected.

Where Are Rates Heading?

We track this economic data to understand the US economy’s heartbeat, and because the market is highly focused on interest rates, we seek signs of when the Fed might lower them.

The Fed’s target for inflation (PCE) is 2.0%. Therefore, it wants a clear downward trend before cutting rates. As long as the economy continues expanding, inflation will likely remain sticky.

So, while last week’s economic data sent mixed signals, Friday’s inflation reading should at least calm some concerns, which it did. The market’s confidence in the first rate cut in September increased from under 50% a week ago to over 55% (as of time of writing).

Does Any of It Matter?

While it’s essential to be informed about economic conditions, it’s crucial to remember that this data serves more as a snapshot of the market’s mood than a definitive guide for making investment decisions.

The market’s obsession with data and rate-cut predictions is often just noise. Making investment decisions based solely on a barrage of economic numbers can lead to short-sighted moves and poor results.

Don’t believe me, then listen to Peter Lynch instead!

So, while I watch the economy and observe how the market’s views change daily, I don’t let these daily mood swings impact my decisions.

Stock Specific News

Salesforce (CRM) and Market Expectations

For me, the most interesting stock news of the week came from Salesforce (CRM). This leading CRM company released its Q1 2025 results on Wednesday. At first glance, the results seemed impressive, yet the share price dropped by -20% the following day.

Why?

Despite a +11.7% revenue growth and over a +314% increase in operating income Year-on-Year (YoY), the market was unsatisfied. Although decent, the next quarter’s guidance also fell short of analysts’ expectations.

The Lesson

Before the earnings release, CRM was valued at over 64x earnings, implying it would take 64 years to recoup your investment if the company’s earnings remained flat. 64 years is a long wait time, so clearly investors expect earnings to grow.

The takeaway is that when a stock is priced for perfection, the company must deliver exceptional results, or the market will penalize the share price.

While CRM might grow its earnings as expected or perhaps even exceed them, I prefer investing in companies priced like it is going out of business because they only need to perform slightly better than expected to please the market. (see “The Liquidation Value of a Company as a Margin of Safety” as an example)

MARKET HIGHLIGHTS FOR WEEK AHEAD

While there is economic data out this week, there is nothing I am overly concerned with, and therefore, I don’t think you should be either.

Earnings are also sparse as no big companies are due to report this week.

I will update you in next week’s newsletter if we miss anything.

INVESTING CHRONICLES

Investing is hard and the best way to improve your own investing is through others. So, under “Investing Chronicles”, I’ll share my learnings from my 18+ years in the stock markets.

“At current levels, we believe the company’s shares predominantly reflect the value of the royalty portfolio, based on the relatively uncontroversial outlook for the company to achieve current and projected future royalty streams from end-market sales of the respiratory products by GSK,”

Goldman Sach Analyst, July 2022

That was the last published comment I found from a reputable analysis on Innoviva (INVA).

That comment was from July 2022, when the analyst had a target price of $16.00 per share.

But this is what has happened to the company since then:

As you can see, INVA has been busy, yet with all that activity, its share price is still below Goldman’s target price of $16.00 per share.

WHY?

Because people aren’t paying attention!

Today, we look at the case study of Innoviva (INVA) and the importance of valuing a business based on its future earnings without the need for complex calculations.

How To Value a Business: The Innoviva Case Study

Investing is laying out money today with the expectation that you will get more back in the future. Therefore, it is essential not to value a business based on its past earnings in isolation but instead look to its potential to grow earnings going forward.

A Brief History of INVA

Innoviva (INVA) was founded in 1996 as Theravance Inc. Its main focus was discovering and developing drugs to combat several diseases, including respiratory.

In 2002, Theravance and GSK collaborated to develop and commercialize respiratory drugs, which led to the successful development of Relvar/Breo Ellipta, Anoro Ellipta and later, Trelegy Ellipta (FDA-approved in 2020). Under the agreement, Theravance received royalties for these products.

In 2014, Theravance split into two businesses, with one arm, Theravance Biopharma, focused on research and development, while the other, Theravance Inc., became the royalty management company, later changing its name to Innoviva in 2016.

The Problem With the Past

If, when I first analyzed INVA in 2022, I had based my decision purely on the company’s revenue, I would have quickly skipped over the business;

As mentioned, in 2022, INVA’s only revenue source was royalty fees from GSK. This revenue stream is about as simple as it gets to forecast because it is based on established products with a knowable lifespan.

Based on the company’s assumptions, analysts’ expectations the royalty business is worth around $1100 million after subtracting ALL the company’s operating expenses.

Of course, we mustn’t forget that the company has liabilities, and we need to exclude those from the valuation of the business . See ”The Liquidation Value of a Company as a Margin of Safety“ for more details on why we do this.

INVA has roughly $520 million in debt but it also has $400 million in liquid assets. So, based on the royalty revenue alone, INVA should be worth approximately $1,000 million. INVA has a current market cap of $992 million, so we are not far off where it should be valued.

But INVA is so much more than a royalty business!

Enter Sarissa Capital

Activist investor Sarissa Capital Management first appeared on INVA’s shareholder registrar in 2017. The highly regarded Alex Denner, a former senior managing director at Carl Icahn’s activist fund Icahn Capital, owns Sarissa.

As things stand today, Sarissa is one of the largest shareholders of INVA with over 10% ownership, while Mr Pavel Raifeld, a former Sarissa employee, is the company’s current CEO. 

Sarissa’s involvement has resulted in a fundamental shift in the company and as a result, it is no longer just a royalty business.

The Opportunity

Royalty Business

The primary source of revenue remains the royalty business. Relvar and Anoro earned the company $238.8 million in revenue for the Financial Year (FY) 2023, and, as mentioned based on my analysis, I value this line of business between $550 million and $1100 million.

The actual value depends on the patent expiration and whether there is a market for the product when generic options become available. The CEO has commented on the difficulty of manufacturing these products and believes it has a longer shelf life past the patent expiration date.

So, it could be worth more than $1,100 million, but, as always, let’s be conservative.

Giapreza and Xerava

In 2022 INVA acquired La Jolla Pharmaceutical for around $210 million. La Jolla Pharmaceutical’s portfolio of products included Giapreza, a treatment to raise blood pressure for adults with septic and other distributive shocks, and Xerava, a therapy for complicated intra-abdominal infections.

Both these products generate revenue for the company, and sales are growing. Below is a breakdown of the revenue growth since INVA took ownership of Ja Jolla.

As you can see, these two products currently generate close to $17 million per quarter in sales, which will likely continue to grow. While it is difficult to predict the exact market size, we can safely value this business based on current revenue of approximately $80 million a year and apply a few simple assumptions.

The math looks like this:

Revenue

$80 million per year

Operating Margin

25%

Conservative for a pharmaceutical product

Operating Income

$20 million per year

80 × 0.25 = 20

Valuation

$200 million

10x operating income is conservative

So let’s value these two products between $80 million (1x current revenue) and $200 million.

Xacduro

Xacduro is an essential treatment as Acinetobacter infections result in high mortality rates and financial burdens on hospitals/patients, while up until Xacduro, there was no effective treatment. It was only made available in September 2023.

Given the current lack of effective treatment on the market, it is difficult to determine the exact market size. However, the US and Europe have up to 100,000 cases yearly, while less developed countries in Asia, South America and the Middle East have far higher cases.

Xacduro has just been approved in China, and in collaboration with Zai-Lab, it should start selling in the country in the coming month. China could be a much bigger market than the US; however, INVA will only earn royalties from sales, but we know how lucrative those royalties can be!

While challenging to value accurately, given that it is so new to the market, I have applied ultra-conservative assumptions. Xacduro could be worth between $100 million and $400 million, potentially significantly higher.

Zoliflodacin

Zoliflodacin is an oral treatment for uncomplicated gonorrhea that has recently completed successful phase 3 testing.

The current treatment for gonorrhea is an injection where one doesn’t want an injection. It is excruciating, and the current treatment is less effective as the bacteria builds resistance. Therefore, a less painful, less embarrassing and, most importantly, effective treatment is required—Zoliflodacin in that treatment.

Around 1 million cases are reported yearly in the US and far more globally. Unfortunately, I have no idea what this treatment could cost, but current treatments are around $20. For now, let’s be ultra-conservative and value the product at between $50 million and $200 million.

INVA will be filing for FDA approval early in 2025.

Other Investments

INVA has invested in many other businesses, including Armata Pharmaceuticals, Gate NeurosciencesInCarda Therapeutics, ImaginAB and Nanolive. These are all clinic-stage companies and, therefore, don’t earn any money.

They are currently sitting on the balance sheet for over $220 million. There is a chance all these businesses will fail and be worth $0, but there is also the possibility that they will produce products with massive potential.

Being conservative again, let’s value these investments between $0 and $220 million.

The ISP Fund

Finally, there is the ISP Fund.

INVA invested $300 million in a fund which invests in listed pharmaceutical and biotech companies. Sarissa Capital manages this fund, and given Sarissa has to file quarterly holdings reports, we can see what the fund is invested in.

A competent team of investors runs Sarissa, so the ISP Fund should be in good hands. As of March 2024, it was valued at $287 million, and given it is invested in listed companies, it should be reasonably liquid.

So let’s value this asset between $200 million (30% discount to March 2024 value) and $287 million (March 2024 value). Of course, there is the possibility this fund will do well over time, but for now, let’s be conservative.

NOTE: This is the one negative about INVA – I don’t like that the main shareholder is paid a 1% annual fee to manage $300 million of the company’s assets to invest in other listed pharmaceuticals. The company should be able to do this themselves.

What is Innoviva Worth

We have been through its assets and their potential while it owns $520 million in liabilities.

So, let’s see what the business is worth:

Business Line

DOWNSIDE

UPSIDE

Royalty Business

                 $550

         $1 100

Giapreza & Xerava 

 70

 200

Xacduro

 100

 400

Zoliflodacin

 50

 200

Other Investments

 - 

 200

ISP Fund

 200

 287

Cash

 178

 178

Deferred Revenue

- 1

- 1

Other long-term liabilities 

- 72

- 72

Long-term Debt

- 447

- 447

Value of INVA ($ Million)

                $ 629

        $ 2 046

Shares Outstanding (Millions)

 63.2

 63.2

Value per Share

             $     9.9

          $ 32.4

Conclusion

Recall that INVA’s share price is currently $15.90 per share, implying a potential downside of -37.5% while the upside is over +100%.

I like those odds!

Especially since I know I have been very conservative in my valuation. I am likely overstating the downside while the upside potential is far greater.

But the real point I am trying to make here is that if you invest in INVA based on its past or current earnings, you would miss out on its true potential. As you can see from the exercise above, INVA is far more than a royalty business, so it is absurd that it is being valued as such.

The Lesson

When we invest in a business, we buy the sum of all its future cash flows so understand what the company is doing and its potential.

And…

Invest in that company when you have a high degree of confidence that it will be worth more in the future than it is today!

LESSONS LEARNED

There is no faster way to learn about investing than through the Greats. Here, I share lessons from the best investors and thinkers.

Given the length of today’s Investing Chronicles, let’s keep today’s lessons learned short.

Peter Lynch Interview

Here is a fantastic interview with Peter Lynch that cuts to the core of what we are trying to achieve as investors. I highly recommend watching.

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