Biotech investing is different from other kinds of investing because biotech is pretty much the only sector in which companies go public before they have a product to sell.

There are plenty of publicly traded companies that are not yet profitable. But they almost always have a product on the market, and you can gauge their progress based on their revenue growth numbers. Management and investors then extrapolate those numbers into the future and try to determine when the company will earn a profit and how much it will earn.

With a pre-revenue biotech, that’s harder to do. Sure, analysts estimate what sales will be for a drug if it’s approved in the future, and then they estimate further how to value the stock based on those sales. But it’s really a guessing game.

When one of these biotechs reports quarterly results with no sales, the emphasis is on the progress of its drug development. Whether the company loses $0.50 per share, $1 per share or $2 per share is basically meaningless. There are two numbers you do want to pay attention to, however: cash and cash burn.

Without a biotech having any sales in the foreseeable future, we want to have a clear understanding of how well financed it is. Does it have enough cash to launch a product? Will it last another three years while conducting clinical trials? Or is it burning so much cash that it will need to raise money by the end of the year if it wants to keep the lights on in 2022?

The nice thing is you usually don’t have to be a math whiz to figure this out. Management will often tell you that it has enough cash to fund operations for a specific amount of time.

For example, Zynerba Pharmaceuticals Inc. (ZYNE), which is attempting to treat rare neuropsychiatric conditions, is forecast to go without revenue until 2024. In its second quarter financial results press release, the company had $85.8 million in cash and stated, “Management believes that the Company’s cash and cash equivalents as of June 30, 2021 are sufficient to fund operations and capital requirements well into the first half of 2024.”

In other words, if everything goes well and Zynerba’s drug is approved, the company may have enough cash to launch the drug without having to raise money. Many biotechs aren’t that lucky. Every quarter, various biotech management teams let investors know they have a year or two worth of cash. And that can be a problem for investors.

When a biotech company needs to raise cash, it usually does so by selling more stock. That dilutes shareholders and often brings down the stock price. Here’s what I mean. If a biotech is trading at $10, has 10 million shares outstanding and sells another 2 million shares to raise cash, existing shareholders just got diluted by 20%.

Whatever profits the company was expected to earn down the road were just watered down by 20% on a per share basis. That will affect the valuation and usually makes the stock fall in the short term.

Biotech stocks, particularly ones in early development, have tremendous potential for price appreciation because a successful drug launch can be life-changing for patients and investors. Understanding when a company needs cash can ensure you don’t get into the stock just before a big downdraft in the share price.