Cannabis industry has flourished over the past few years and it continue to grow further driven by favorable regulatory environment, increasing aging population and growing prevalence of chronic illness resulting in increasing number of medical marijuana patients. After decades in the shadows, the cannabis industry has evolved manifold due to changed public opinion surrounding cannabis legalization.
Legalization of recreational cannabis is a major development in Canada and few states of the US, grabbing the attention of many mainstream investors as cannabis stocks have shown exponential growth, outperforming major indexes and other sectors from 2016. Legalization in the cannabis industry also presents enormous opportunity for large players to capture a meaningful share in the global market through mergers and acquisition. The cannabis industry is ripe for sizeable consolidation, and the pickup we have experienced in last years is probably only the beginning. Ever escalating M&A has placed increased importance on transparent and robust business valuation in this industry.
There is gamut of complications and complexities that exist in business valuation in cannabis industry including limited operating and financial history of many cannabis company, uncertainty around regulatory environment, and continuously shifting industry fundamentals. There are three approaches that are majorly used to value a cannabis business valuation.
Let’s discuss valuation approaches to be used in cannabis valuation:
1. Asset Approach
An asset-based approach also sometimes referred to as cost- based approach is a valuation methodology that focuses on adjusted net asset value which is determined by subtracting fair market value of the business’ assets and its liabilities. There are two methods under asset-based approach, namely Net Liquidation Method and the Net Asset Value method.
- Net Liquidation method calculates the value of the business based on the expected proceeds to be realized at the time of liquidation of the company’s assets as a part of company’s dissolution. The method is often used when business is continuously unprofitable and best value can be realized by selling the underlying assets.
- Net Asset Value method is when all assets and liabilities of the business are adjusted to their fair value or “economic value” and their difference is determined. A valuation analyst can also use the cost of producing or replacing the asset, less an allowance for obsolescence and physical deterioration.
Within cannabis business, asset approach is most appropriate in the following situations:
- the company is going concern;
- the company’s value depends significantly on the value of its tangible assets;
- the company has little or no identifiable intangible assets;
- the balance sheet reflects all the company’s assets
- a business operating at a loss with expectation of continuing losses in the future.
2. Income Approach
Income based approach is built on the theory that the intrinsic value of a business is based on expected future benefits or earnings, discounted at an appropriate rate of return reflecting market rate of return expectations, market conditions, inherent risk and opportunity cost of investment. Income-based valuation method requires the following inputs;
- Net cash flow projections: Financial projections of amount of cash produced by business after paying for all operating expenses and capital expenditures.
- Discount Rate: It refers to cost of capital/rate of return used to determine the present value
- Terminal Value: It is value of the business at end of the projection period.
Two methods under income-based approaches that are primarily used are Capitalized Future Earnings methods and Discounted Future Benefits method.
- Capitalized Cash Flow (CCF) method involves determining the value of the business by dividing a single period cash flow stream deemed representative of the future by the capitalization rate (cap rate).
- Discounted Future Earnings method involves using projections for the earnings of the firm and discounts these back to the present using an appropriate discount rate.
Application of income approach in the valuation of cannabis business requires certain considerations which we will discuss below in detail.
Cash flow projections forms a key part of a discounted cash-flow method based on which value of business is derived. The cannabis industry is at embryonic stage; therefore, it is marked by constant change and high growth rates which makes it difficult to predict earnings for a longer period. Another major challenge in forecasting is that future cannot be predicted with absolute certainty due to lack of historical financials. When preparing projections, it is crucial to perform thorough analysis of financial and non-financial information, external and internal factors.
List of Factors to Consider in Financial Projections
Financials of a company often involves one-time gains/losses, income/expenses and other unusual that are not a part of regular business operations. Normalization adjustments remove the effect of such discretionary, non-recurring and non-operating items to show true financial position of the company.
List of Items requiring Normalization Adjustments
Discount Rate (Cost of Capital)
Income approach uses a discount rate which represents level of risk associated with an investment and it is used convert expected future benefits into the present value. Computing a correct risk-adjusted discount rate is a major challenge when using income approaches in the valuation of cannabis business. A valuation analyst incorporates various risk considerations in the risk assessment phase.
3. Market Approach
Market approach involves determining the value of a business based on pricing and Enterprise value multiples derived from the business and sale of companies similar to the subject company. There are two major types of market approaches used by valuation analysts: Guideline Transaction method and Guideline Company Method.
- Guideline Company method compares subject company with similar publicly traded companies.
Applying market approach in the valuation of a cannabis business presents several challenges for valuation analysts as limited market data is available in the cannabis space. Although, market data has begun to emerge in the market as cannabis industry has grew over the last few years but is still far from becoming a mature industry. Also, there are significant jurisdictional differences inherited in the cannabis industry such as tax burdens, licenses, sociopolitical environment, and state and local regulations. For example, in some states of the United States, both medical and recreational marijuana is legalized whereas in some states only medical marijuana is legalized. Similarly, cannabis is legal in Canada so Canadian business environment is more cannabis friendly than United States.
Most commonly used multiple in market approach is enterprise value (EV) to earnings before interest, tax, depreciation and amortization. The table below illustrates the financials and respective multiples for the 10 largest Canadian cannabis company. There is a huge variability in the multiples as of August 2019, EV/ LTM Revenue ranging from 7.2x to 175.7x and EV/ LTM EBITDA ranging from -13.2X to -186.5x. Most of the comparable companies are reporting low or negative operating profits due to low revenues and high operating expenses. Most of the companies in cannabis industry are at early stage and are making significant operating investments to meet the anticipated future demand and capturing market share. Multiples due to low historical profitability are less indicative of expected future growth from legalization of recreational cannabis and other global expansion opportunities. Therefore, it makes sense to use forward looking multiples in the cannabis valuation, which is price paid today, reflecting expected company’s financial tomorrow. The average EV/forecasted revenue in 2021 is 7.1X, as against an average EV/LTM revenue of 72.7x. Similarly, the average EV/forecasted EBITDA in 2021 is 79.1X as against an average EV/LTM EBITDA of -68.0x. Forward – looking multiples are believed to result in more reliable and logical valuation as compared to use of traditional public company multiples. An alternate approach is to use market multiples of similar but more mature industries that are considered most comparable to cannabis, such as alcohol and tobacco to get a value of a value of a mature market.
A valuation analyst can also use market ratio analysis to build a valuation model for the subject company by determining reasons for the difference in multiples. For example, company X have a market capitalization of $1,000,000 and it has generated $100,000 in earnings, trading at a P/E multiple of 10x. The company y that also have a market capitalization of $1,000,000 but it has generated $200,000 in earnings, presenting a P/E of 5x. There can be several reasons to explain why company Y is cheaper as compared to company X based on price – to -sales multiple, such as differing growth prospects, product pipeline, stage of operations, and pending lawsuits.
Multiples for Largest Canadian Companies in Cannabis Industry
- Guideline Transaction method compares subject company with the similar companies that have been acquired or merged within a reasonable proximity of the valuation date.
Finding comparable transactions and meaningful market multiples to use in cannabis valuation can be challenging. Similar to the guideline company method, most of the target companies in the guideline transaction method are in growth stage and have low or negative profitability, therefore result either in too high multiples or negative multiples which are not meaningful. In the table below, the average implied EV/ LTM revenue multiple is 400.6x and the average implied EV/ LTM EBITDA multiple is -37.5x.
Implied multiples of Precedent Transactions in the Cannabis Industry
Given many target companies are privately held companies, getting forward looking multiples will be difficult. Therefore, while applying precedent guideline transaction approach, a valuation analyst can evaluate the extent to which the buyer has paid strategic premium for the post-acquisition synergies.
Limitation of Cannabis Valuation
- Regulatory Issues: Cannabis is federally illegal under the Controlled Substance Act of 1970. Although the federal government currently permits states to self-regulate the legalization of medical or recreational marijuana, the possibility of federal government to intervene and distort the cannabis industry has kept many operators and investors on the sidelines due to the risk of abetting. From the appraiser point of view, it is challenging to measure this risk and incorporate it in the valuation model.
- Extraordinary Tax Burdens: Every business that earns profit pays taxes in the US, however, different taxable rules apply to cannabis industry as it is illegal at federal level and the taxing department impose additional scrutiny on the cannabis companies. IRC Section 280E mandates that all the cost except those directly linked to the production, processing and storage of cannabis should be treated as non-deductible items for determining taxable burden. This can lead to low profitability for otherwise successful operating businesses. Computing the federal income tax and fulfilling reporting requirements can be a challenge due to complex tax rules and lack of competent professionals to assist in compliance with these rules.
- Constant Industry Evolution: Cannabis industry is in flux and is subject to constant change which can disrupt normal business operations. Companies in the cannabis space are making huge investments in establishing high-tech operating facilities and protocols, therefore any change in the industry can impact these investments significantly.
- Lack of Market Data: Application of market approach for the valuation of cannabis company is a challenge due to lack of closely comparable companies and transactions to derive market multiples. Most of the companies in the cannabis industry are at the early stage and are reporting low or negative profits, resulting in meaningless multiples. Also, rules and regulations in the industry differ at country, state and jurisdiction level which makes it difficult to compare companies operating in different regions.
- Dependence on Perspective Data: The financial projections of expected future cashflows in the income approach to the valuation are developed based on the impact of a range of business scenarios over the several years. Given the limited operating history of most cannabis companies, use of historical data to arrive at expected future cash flow may not give reliable results. Additionally, complex income tax rules applicable to the industry make the projections even more discrete.
The cannabis industry is continuously evolving driven by shifts in regulatory landscape, industry dynamics and increased consolidation in form of mergers and acquisition. The large players continue to push the boundaries of growth by entering in new markets and pursuing strategic acquisition and partnerships. Fundamentals of cannabis industry differ significantly from other mature industries; therefore, traditional valuation methods and metrics are often less meaningful given the industry is still in its growth stage and is highly volatile. The appraisers may place more importance on the forward-looking multiples believing that the industry would witness a noteworthy upside in coming years, which can result in misleading value.
It is important to note that a lot of professional judgement goes into financial projections and determination of discount rate under the income approach and selection of multiples under market approach. For rigorous valuation one must always be aware of evolving landscape, federal and state rules and regulations, market size, and information about operating costs and revenues across the value chain associated with the cannabis industry.