A new mentality is sweeping Wall Street, leaving many companies shell-shocked. The US equity market's worst performance since the crash of the late '80s has many looking for scapegoats. In response, institutional investors are focusing more intently on the underlying earnings power of each company in their portfolio. They are scrutinizing business models with an eye toward a company's ability to generate future cash flows.

The effect of that change is most pronounced for small-cap growth companies, particularly in the biotechnology, pharmaceutical, and medical device sectors. In the past, the perceived value of life science companies was rooted in innovation, not business models. In today's tumultuous marketplace, such companies have no choice but to align their business models and investment stories with Wall Street's new standards.

Unfortunately, the reality is that many life science companies still continue to talk grandly of the potential for blockbuster drugs or revolutionary technologies. Such stories fall on deaf ears. This article examines the disconnect between life science companies and Wall Street and provides specific guidelines to improve investor communications. Companies that are able and willing to explain how their initiatives translate into future cash flows will be the clear winners in the valuation race.

The reality is that communications plays a critical role in the valuation process, especially during uncertain market conditions. Investors value companies based on projected future cash flow, which requires that companies convey a great variety of information.

Because past performance is considered a poor predictor of future performance, investors rely heavily on qualitative information that links corporate strategy and future cash flows. That qualitative evidence is the "missing link" for many esoteric, complex life science stories. Without it, investors will simply turn to more easily understood and valued alternatives.

Institutional investors seem to have presented life science companies with an ultimatum: either help us assess the return and risk profile of your business with relevant, accurate, and transparent financial disclosure or risk being significantly undervalued.

"The price companies pay for secrecy is more suspicion from a potential investor, explains Frank Boriello, MD, PhD, BB Biotech AG/Bellevue Asset Management. "It's a trade-off. If a company wants to keep something out of the public domain, there will always be an increase in risk."

Failing to comply with the demand has been devastating for some companies. The life science sector as a whole has underperformed relative to the overall market. During the past 12 months, the S&P Small Cap Biotechnology and Pharmaceutical Index has fallen more than 35 percent, compared with a 29 percent downturn for the broader S&P 500 Index, a -24 percent for the NYSE Composite, and a -21 percent for the Dow Jones Industrial Average.

Failure to CommunicateWall Street's frustration in valuing profitable life science companies can be narrowed to three common problems:

Different perceptions. Many companies overlook the fact that an investor's perception of a company's ability to execute may be substantially different than that of management. The perceptual gap widens when companies fail to make information available, and the result is a high level of uncertainty. Although investors typically use mathematical equations such as the weighted average cost of capital (WACC) and the capital asset pricing model (CAPM) to determine a company's cost of capital, the single greatest factor influencing that critical input is uncertainty. A high level of uncertainty and a high cost of capital bring a low valuation.

Consider a small-cap life science company that signs a potentially lucrative partnership with a large pharma player. To avoid unduly raising investors' expectations, management decides not to disclose details of the transaction. Yet, to the detriment of all stakeholders, the deal adds very little to the company's valuation because investors are unable to quantify its financial impact.

"Sometimes companies strike deals in which they are unable to, or do not want to, disclose the exact terms. How are we supposed to know whether to put a royalty of 3 percent or 20 percent on it?" asks Boriello. "That becomes an uncertainty."

The flow of cash flow. Wall Street investors expect companies to reinvest cash flows in their business if new projects yield a higher return than the cost of capital. If expected returns fall short, cash flows should be returned to shareholders through a dividend or stock repurchase.

But profitable small-cap life science companies rarely return cash flows to investors despite the fact that many are having difficulty finding value-enhancing projects. Consequently, cash sits as excess surplus on the balance sheet, hampering return on investment comparisons and casting a negative perception on the company's future growth potential. Additionally, if the money is not being invested in the underlying business, it likely is being invested in money market accounts or marketable securities. In effect, companies play quasi-asset managers with investors' capital. That is a tough pill for Wall Street professionals to swallow.

Lack of detail. The most egregious and common problem stems from management oversimplifying the company's financial condition by communicating only revenue and earnings per share (EPS). Although those are popular metrics, there are many others even more critical to investors' analysis.

"A lot of companies just give you that top line projection: 'We are going to grow X percent in '03.' Obviously, more detailed information gives us a better understanding of how they plan to hit their targets, "says James King, portfolio manager for US Bancorp Asset Management. "Anything that a company can do to help the institutional investor better understand how they make money gives us more confidence in their ability to execute their strategy. When we have greater conviction, we are more inclined to buy those stocks."

Credibility is the number-one factor influencing whether investors believe a company's guidance. Therefore, life science businesses need to establish the appropriate support for how management will execute its strategy and achieve its projected goals. In the absence of credibility, support cannot exist. A guidance with only revenue and EPS is analogous to a classified advertisement-it may hit the high points but rarely will it induce an immediate sale. To complete the sale, investors must feel confident in management's credibility.

Connect with Investors As a first step, management must go beyond seeing its company as a creator of innovative science and technology and understand what investors want to see-namely, an investment supported by underlying cash flows. For profitable small-cap life science companies, the ability to lay out their return and risk profile for institutional investors is far easier than for companies still in the venture stage. However, there is no benefit in simply demonstrating historical profits. Management must help translate industry-specific jargon to meaningful financial terms that every investor can relate to the business model.

Following are guidance principles that life science companies should adopt to ensure effective communications with investors:

Key initiatives. Support revenue projections with a detailed account of critical business initiatives. Go beyond segmenting business lines and highlight key factors that will positively affect revenue contribution, enabling investors to focus on the company's true source of value. In the absence of a key initiative guidance, investors may overly penalize a company for an initiative they do not support if they perceive that it contributes more to revenues than it actually does.

Predictable revenues. Highlight revenues that have a high probability of contributing in the future, such as backlog and recurring revenue. Investors prefer predictable revenues to risky or erratic revenues. Accordingly, they will feel more comfortable with the company's projections and apply a lower cost of capital in valuing the company.