With the growing legal marijuana market, many cannabis investors are eager for cannabis investment opportunities.
Starting a marijuana business is gaining a lot of popularity due to its potential to drive massive growth and huge revenue. As per Brightfield Group, the hemp CBD market can reach about $22 billion by 2022.
Whether you are planning to invest in a marijuana business or cannabis stocks, your game is for a healthy return on your investment; however, not everyone is lucky enough to thrive in the changing marketplace. There are plenty of laws and regulations that make it a challenge to run a marijuana business profitably and thrive in this industry. Also, misunderstandings about the plant and the taxes create hindrance in generating profits.
Thus, it is imperative to understand how to valuate a cannabis business to purchase or a cannabis investment to pursue and understand what cannabis investment funds to avoid before you jump into the cannabis industry. Valuations will help you measure how efficient or profitable the business or investment has been and, theoretically, could be down the line.
Tracking the business value also offers you a chance to create a timeline for potential sales and other exit strategies. The comprehensive road map also helps you adjust your short-term or long-term business goals.
Common Methods Used for Performing Valuations for Cannabis Investment
Cannabis investors, businesses, and industry experts use a variety of valuation methodologies and tools to identify the worth of a business as a cannabis investment or the outright purchase of a cannabis business. Let’s dig into each of these analytical approaches.
1. Asset-based Valuation
Asset-based valuation (also known as cost-based approach) is a technique that focuses on the assets and liabilities to get the bigger picture of the cannabis business value.
The net asset value is determined by the fair market value of the total assets minus liabilities. The assets can include both tangible assets like plants, equipment, and staff.
There are two techniques under this valuation methodology:
a) Net Liquidation
The net liquidation calculates the business value depending on the expected proceeds at the time of liquidation of the assets.
Investors use it when business is continuously in the loss, and the best value is determined by selling underlying assets.
b) Net Asset Value
Net asset value method includes adjusting all the assets and liabilities to the fair value and determining their difference.
Asset-based valuation is perfect in the following situations:
- The value of the company relies hugely on the value of the tangible assets;
- The balance sheet shows all the assets;
- The agency has little or no identifiable intangible assets;
- A business in a loss with the expectation of continuing losses in the coming years.
Example of Asset Valuation:
Let’s get the net asset value for Alphabet Inc. GOOG. All the following figures are for the period ending Dec. 31, 2018.
Total assets: $232.8 b
Total liabilities: $55.2 b
Total intangible assets: $2.2 b
So, $232.8b minus $57.4b ($55.2 + $2.2b) equals the total net asset value $175.4 b
2. Earnings-based Valuation
This valuation method involves reviewing the historical performance blended with its projections with a discount rate applied to future cash flow. It signifies the present value of the cannabis business on an income basis.
Investors use this technique when the business or asset has a steady history of earnings and incomes with a sign that the revenues will continue in the years to come.
Example of Earnings-based Valuation:
To determine a company’s earnings in association with its price, most businesses use a P/E ratio. This ratio relates to a company’s share price to its earnings per share.
A high price per earnings ratio means that the stocks of the company are overvalued, or the investors are expecting better growth rates in the upcoming years.
To determine the P/E value, simply divide the current stock price by the last four quarters of earnings per share (EPS).
You can calculate the EPS by simply dividing the dollar amount of the earnings of a company by the number of outstanding shares. So, if our example company, X INC has 1 million outstanding shares, and it’s earned $1 million in the past 12 months, it has a trailing EPS of $1.
$1M in earnings / 1M shares = $1 earnings per share (EPS)
Then, we calculate the stock price and divide it by the last four quarters’ of earnings to come up with the P/E ratio.
For instance, if X INC is trading at $15 a share, it would have a P/E ratio of 15.
$15 share price / $1 in EPS = 15 P/E
3. Market Comparable Valuation
The market comparable analysis involves digging and analyzing the market of the buyers or investors who have paid for other private businesses.
Mostly, the investors evaluate a canna-business in terms of a multiple of EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization). It is a proxy for the current profitability of a business.
Analysts use two market approaches:
a) Guideline Company method
It involves comparing the cannabis company with similar publicly traded agencies.
b) Guideline Transaction method
It involves comparing the cannabis company with similar companies that have merged within reasonable proximity of the valuation date.
Example of Market Comparable Valuation:
If an X company trades at a 10 times P/E ratio, and company Y earns $2.50/share, Y company’s stock must be worth $25.00/share. See the table below for other examples.
4. Replacement Valuation
Another method that businesses use to evaluate their company’s value is replacement valuation. It involves estimating what price you need to pay if you want to build the marijuana business again from scratch.
In some cases, would-be purchasers of a business perform a build-vs.-buy analysis (assessing what it would cost to start at zero, price of hiring the management team, and imitating the business).
Replacement Costs Example:
Company ABC balance sheet:
| Liabilities | $ (1000s) | Assets | $ (1000s ) |
| Equity share | 1500 | Fixed assets of the company | 3000 |
| Preference share capital | 600 | Total inventories | 1350 |
| Surplus and Reserves | 300 | Bank balance and cash | 150 |
| Short-term debt | 300 | Debtors | 300 |
| Long-term debt | 900 | ||
| Creditors | 1200 | ||
| Total amount | 4800 | Total amount | 4800 |
| Book Value Calculation | $ (1000s) |
| Total assets | 4800 |
| Less short-term debt | 300 |
| Less Long-term debt | 900 |
| Less creditors | 1200 |
| Book value | 2400 |
As mentioned in the table, the book value is $ 2,400,000. Now we will calculate the replacement cost using the following assumptions:
- The asset market value is 50% higher in comparison to the total accounting value in the balance sheet.
20% of the fixed assets are not in use - The replacement cost in the balance sheet will now contain the fixed assets value, as shown below:
| Fixed Assets | $ (1000s) |
| Original asset cost | 3000 |
| Less Unused assets | 600 |
| Total balance | 2400 |
| Post revaluation at 150% | 3600 |
As shown in the table, the asset value has hiked by $ 600,000, i.e., $ 3,600,000 less $ 3,000,000.
New Replacement Cost in the Adjusted Balance Sheet will be:
| Liabilities | $ (1000s) | Assets | $ (1000s) |
| Equity share capital | 1500 | Fixed assets | 3600 |
| Surplus and reserves | 300 | Bank balance and cash | 150 |
| Preference share capital | 600 | Inventories | 1350 |
| Adjustment | 600 | Debtors | 300 |
| Short-term debt | 300 | ||
| Long-term debt | 900 | ||
| Total amount | 5400 | Total amount | 5400 |
Calculation of replacement cost value:
| Replacement cost value | $ (1000s) |
| Total number of assets | 5400 |
| Less short-term debt | 300 |
| Less long-term debt | 900 |
| Less creditors | 1200 |
| Replacement cost value (Net Substantial Value) | 3000 |
Therefore, the value of the company is $3,000,000.
5. Sensitivity Valuation
Most of the cannabis business owners do a sensitivity analysis of the future value of the cannabis company. They do this to find out the reasonable expectations are for future value.
Companies valued on a multiple of revenue are mostly preferred because the buyer is most interested in the value of the revenue of the company.
However, the companies sold and bought depending on the EBITDA multiple is a signal that either the buyer or investor wants to boost the business profit.
Example of Sensitivity Valuation:
Mary is a sales manager for Headshop Corp that sells vaporizers and cannabis accessories at a shopping mall. She wants to find whether massive customer traffic at the mall in the next holiday season will increase the total sales revenue of the company. If so, then by how much.
The average price of a marijuana accessory is $20. In the past Holiday Season, Headshop Corp sold 500 grinders and storage boxes for a total of $10,000.
After performing a Sensitivity Analysis, Mary determines that a 10% increase in traffic leads to a 7% boost in sales.
Using this data, she can forecast how much money the company will generate if the traffic increases by 20%, 40%, or 100%.
Wrapping Up:
When investing in the marijuana industry, it is crucial to proceed with a true understanding of the risks involved and the potential outcomes. Determining what is the best cannabis investment in the cannabis industry and understanding the marketplace can help mitigate risks.
But how can investors evaluate which opportunities are good and which are bad bets? The answer is simple and very complex: It’s via an in-depth valuation of the cannabis business or investment.
For this, you need to become familiar with the changing landscape, market size, cannabis investment network, federal and state regulations, revenues across the value chain, and operating costs associated with the niche.
What method or methods do you use to evaluate your possible cannabis investments?