Cannabis Industry: What are the Valuation Considerations?

Published on 01 Jun, 2020

Valuing US cannabis companies is a challenging task that requires expertise and in-depth financial knowledge. Various issues such as lack of historical data, ambiguous taxation laws, and unbanked transactions add to the complications. Can these obstacles be overcome by employing a systematic approach to carry out valuation?

Cannabis companies in the US are currently in a high-growth phase and awaiting federal and state approvals. In such a scenario, significant investment and acquisition activities are expected within the industry to capture market share and meet the anticipated future demand. Increasing merger and acquisition activities have created complexities and a need for judgement-based business valuations vis-à-vis the valuation of businesses in traditional or mature industries. Some of the challenges faced while valuing cannabis companies include limited financial and operating history, uncertain regulatory environment, limited confidence on projections, and evolving industry fundamentals.

Timing of cash flows contingent on federal legalization
A milestone for the cannabis industry was the passing of the Marijuana Opportunity Reinvestment and Expungement Act, a bill to legalize marijuana at the federal level, by the US House Judiciary Committee in November 2019. However, the bill requires further approvals from the House of Representatives and Senate to come into effect. Considering the conflicting ideologies followed by the controlling political parties in both the houses, the timeline of approval is unpredictable. The upcoming US election has further added to the uncertainty. Moreover, the ongoing coronavirus pandemic has diverted the focus of regulatory authorities to the country’s health and economic issues. Nonetheless, experts are optimistic that once the pandemic recedes, the federal legalization process would be accelerated, as it could help improve the economy and employment rate.

As cannabis is federally illegal, cannabis producers are unable to export their products to other countries or transport to other states where use of cannabis has already been legalized. Despite having invested significantly in production facilities, the companies are forced to await favorable regulations to reach their true potential. Hence, measuring the riskiness of the project is a challenge. A final legalization at the federal level may help the companies build scale and reduce marginal costs, improve branding strategies, and enhance financial projections.

Valuation of cannabis companies based on projections instead of historical data
The industry’s limited financial and operating history may not be the best indicator of future operations. Due to the current uncertain regulatory environment and on-going acquisitions, financial projections of cannabis companies are typically based on multiple scenarios. Hence, highly rigorous analysis of projections is required while applying an income-based approach.

The availability of limited comparable companies and precedent transactions makes it difficult to apply a market-based approach. Some of the comparability challenges include different rules and regulations at state and county levels, multi-state versus single-state operators, and vertically integrated versus non-vertically integrated companies. Moreover, due to the industry’s limited history and recent high-growth phase, cannabis companies are predominantly operating at low or negative profits. This results in meaningless current and historical multiples.

Additional valuation complexities due to heavy tax burdens and high scrutiny from the IRS
Cannabis companies are required to comply with IRC Section 280E, which forbids standard deductions for companies engaged in the production of controlled substances. The companies can therefore claim only direct costs, which hinders profitability. Many cannabis companies are grappling with complex rules and opposing the Internal Revenue Service (IRS). According to a report published by a branch of the US Treasury Department, the IRS plans to increase the audits of cannabis companies, as it suspects companies to be violating Section 280E, leading to significant amount of unpaid taxes. From a valuation standpoint, projecting post-tax cash flows can be tricky, particularly for vertically integrated companies. Erroneous interpretation of rules can lead to material change in valuation. Additionally, the taxation rule allows limited comparability with similar highly regulated industries such as alcohol and tobacco.

Unbanked high-risk cannabis companies face challenges in obtaining adequate funding
Banks are regulated by the federal law. Therefore, they may face federal prosecution if they service the marijuana business, which is federally illegal. As a result, banks avoid servicing cannabis companies. It is difficult to scrutinize the transactions of unbanked companies and assess their financial statements.

Moreover, companies face difficulties in obtaining substantial capital due to their high-risk profiles. Considering the capital-intensive nature of the business, limited sources of funding could pose a huge risk for operations. From a valuation perspective, this may create a material impact on projected cash flows. Additionally, lack of transaction history or audit trail may result in questionable reporting of revenue and profitability, leading to speculative valuation.

Need for careful analysis of market multiples
Under the market-based approach, valuations are calculated by benchmarking multiples or ratios of similar assets. Hence, it is of utmost importance that the multiples exhibit apple-to-apple comparison. In an acquisitive industry, companies frequently close/announce/cancel acquisitions. In such situations, analysts should ensure that the effect of the transaction has been considered accurately in both the numerator and denominator of the multiples. Typically, a financial consensus forecast includes the effect of announced acquisition transactions; however, new shares to be issued for the acquisitions are not considered in market capitalization calculation until the transaction is closed. As a result, the market capitalization of the acquirer is understated, resulting in low (inaccurate) multiples.

Questionable fairness of transactions due to volatility in stock prices
Assessing fairness of transactions based on current or historical multiples may not be the best approach. A low revenue base or negative/low profitable base leads to higher-than-usual valuation multiples. Furthermore, the valuation levels of cannabis assets have changed drastically for the companies operating in states where recreational use is premitted. The Marijuana Index of the US declined to around USD30 in April 2020 from around USD130 in April 2019, the lowest level in three consecutive years. Therefore, valuation multiples of past transactions may not prove to be valid benchmarks in current valuations. These transactions reflect the initial euphoria regarding the cannabis industry’s prospects and investors have rationalized their expectations over the period, due to underperformance of the industry. The dominance of illegal channels, restrictions on advertisements/branding, and delays in issuing licenses/approvals continue to hold back the legal cannabis industry.

To conduct a comprehensive valuation analysis, appraisers must be aware of rules and regulations, evolving industry fundamentals, and their combined impact on company-specific fundamentals. Considering the factors mentioned above, it can be concluded that good judgement and significant experience are prerequisites for conducting valuations of cannabis companies.

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