It seems the market beat me to the punch today, knocking shares in Prima BioMed Limited (ASX: PRR) down 45%, after an incredible 604% increase in its value earlier this week.

So while shares are still substantially higher than they were on Monday, today’s fall probably caught a few investors out and is a stern reminder of the risks of investing in speculative biotechs:

  • Shares can go up AND down

No stock ever just went up and up – wonder biotech companies included. Today’s fall looks like classic profit-taking, but there’s ample potential for future falls to be caused by real problems.

  • The risks are enormous!

If you’re in a position to make a 600% profit in a week – or a year for that matter – it’s almost always because you’re taking on massive amounts of risk. ‘Jackpot’ rises like Prima BioMed recently are also extremely rare.

  • You’re subscribing to the ‘greater fool’ (lower case f) theory

If you’re buying a speculative, loss-making stock looking for price gains, you’re basically saying ‘well, I think I can find a bigger fool than me to sell this to for a higher price in the future’. It’s not usually a winning strategy.

The above risks can be said to apply to any speculative stock. There are a number of unique concerns that prospective Prima investors should also be worried about:

  • Losses and cash burn

Prima lost $6.4 million dollars in the six months to 31 December 2014, leaving it with $5.7 million in cash – not even enough for another six months’ operation. Those funds have since been topped up by a $15m investment from US health investor Ridgeback, but cash outflow remains a major concern. Investors should also note that Ridgeback’s funds are being valued at between 1.73 and 2 cents per share, probably a better reflection of what the company is actually worth.

Furthermore, it took five years to conclude the CVac trial that sent Prima’s shares soaring recently – and that was only a phase II trial. I don’t believe Prima has the cash to fund another five years of research, and phase III trials are typically larger and more expensive than phase II.

(Readers wanting to learn more about trial phases and investing in biotech stocks can check out my three-part article on the subject here, here, and here)

Shareholders are already being tapped for additional funds, which leads straight to the next problem:

  • Shares on issue

Prima BioMed has 1.5 billion shares on issue, with more to come thanks to capital raisings. For illustration’s sake, let’s assume Prima earns 0.5 cents per share, giving it a Price to Earnings (P/E) equation of ~20 based on today’s prices.

Those figures mean that Prima needs to earn $750 million per annum in profit in order to have a P/E of 20 at today’s prices. Prima currently earns $0 in revenue, let alone profit. It will be years until Prima is making that kind of money, and with so many shares on issue there is no room for prices to move higher – earnings will never justify it.

  • Testing

In addition to being expensive, treatment trials are fraught with risk. As Sirtex Medical Limited (ASX: SRX) investors found out to their cost recently, positive trial results are impossible to guarantee. Even highly promising drugs routinely fail to meet the scientific hurdles required for them to become accepted as treatments.

  • Selling new products

Even if Prima successfully completes all its trials and is able to commence sales, there’s no guarantee the company will make money. Admedus Ltd (ASX: AHZ) is a classic example of a biotech hopeful that ‘made it’, but still isn’t profitable despite having developed a working product.

Picking a successful biotech stock is extremely difficult, and I can virtually guarantee that the companies to buy are NOT the ones that experience soaring share prices. Reliable performance will beat speculative stocks over the long term, and with far less risk. Needless to say I’m steering well clear of Prima BioMed at today’s prices.

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Motley Fool contributor Sean O'Neill owns shares in Admedus. The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.