The valuation of businesses associated with the cannabis industry offers valuation experts a myriad of opportunities. A multitude of challenges faced by industry operators present unique challenges for a valuation analyst. Valuations must carefully consider the economic, industry and specific company risks associated with the subject company. Industry-specific considerations include regulatory complexities that can vary on a state-by-state basis.
On a recent episode of Freakonomics Radio titled “Cannabis is Booming, So Why Isn’t Anyone Getting Rich?” key insights were offered, including regulatory uncertainty, state-specific laws, and a federal prohibition, creating a complex legal landscape that complicates risk assessment and financial forecasting. Additionally, high taxes and competition from illegal dispensaries further strain the profitability of legal cannabis businesses. Fluctuating wholesale prices, evolving consumer preferences, and emerging product categories contribute to market instability. All the aforementioned items make historical data less reliable than well-established businesses working in the confines of a stable industry. As a result, historical trend analysis may not be particularly useful in the development of financial projections.
Valuation Methods
The three primary methods for valuing cannabis businesses are the income, market, and cost approach—let’s explore each of these methods a little closer.
Income Approach
The income approach is predicated upon the value of the future cash flows that a business will generate over its remaining useful life. The capitalization of earnings method relies on historical cash flows to estimate future cash flows while the discounted cash flow (“DCF”) method involves a projection of the cash flows that the business is expected to generate. Typically, the DCF method is used to value cannabis business due to the high volatility of historical cash flows.
Creating an income statement forecast for a cannabis business involves considering several unique factors. For retail stores, it’s important to estimate the number of stores in the area and their expected sales. For cultivators, key elements include the square footage of growing space, yield per square foot, and the product mix. Additionally, since cannabis businesses cannot operate across state lines, the forecast must account for the specific pricing and margins in each state. The number of licenses in the area is also a crucial factor.
When conducting a DCF analysis for the cannabis industry, tax considerations are particularly important. Section 280E of the Internal Revenue Code prohibits businesses from deducting expenses related to federally illegal substances, such as cannabis. This section only permits the deduction of the cost of goods sold and disallows the deduction of operating expenses when calculating federal taxes. Some states, such as California, have decoupled from Section 280E. This allows cannabis businesses to deduct ordinary business expenses that are disallowed under federal law due to Section 280E. The potential rescheduling of cannabis could eliminate Section 280E, but it remains uncertain when this change might happen. Net operating losses (“NOLs”) should also be considered. A net operating loss (NOL) occurs when a company’s allowable tax deductions exceed its taxable income within a tax period. This loss can be used to offset taxable income in other tax periods, providing tax relief by reducing future tax liabilities.
The discount rate applied to present value the cash flows of cannabis businesses is generally higher because of the regulatory and other associated risks.
Market Approach
Under the Market Approach, the value of a business reflects the price at which comparable businesses are purchased.
The Guideline Public Company (“GPC”) method of valuation is based on the premise that pricing multiples of publicly traded companies can be used as a tool to be applied in valuing closely-held companies. There are several cannabis publicly traded companies. When selecting a multiple, the valuation analyst should consider the size, profitability, leverage, liquidity, and growth of the subject company compared to the GPCs. The valuation analyst should consider the state or states the GPCs operated in as the market can differ substantially between states.
The Guideline Merged and Acquired Company (“GMAC”) method is a valuation approach used to estimate the value of a company by analyzing the prices at which similar companies have been merged or acquired. Similar to the GPC method, the valuation analyst should compare the target of the transaction to the subject company in order to select a multiple. There are several sources of transaction databases. Viridian Capital Advisors’ “Cannabis Deal Tracker” offers valuable data on deal activity, helping to identify relevant benchmarks and assess market conditions.provides deep insight into M&A activity, capital raises, and valuation trend. Viridian helps investors and companies understand market dynamics and make informed capita allocation and M&A decisions by tracking deal flow and analyzing transaction data.
Cost Approach
This method would likely not be used especially if the value of future income streams is expected to exceed the adjusted net book value at the valuation date. The cost approach would fail to capture the values of intangible assets like brand recognition, licenses, and customer relationships. The cost approach might be used to value cultivation facilities due to the high level of fixed asset investments.
Valuing businesses in the cannabis industry presents unique opportunities and challenges for valuation experts. Analysts must consider economic, industry, and company-specific risks, with regulatory complexities varying by state. Issues such as regulatory uncertainty, high taxes, competition from illegal dispensaries, fluctuating wholesale prices, and evolving consumer preferences, all contributing to market instability. These factors make historical data less reliable for financial projections. The primary valuation methods used are the income, market, and cost approaches.
Authors: Alex Weis, MBA | [email protected] and Trevor Shaw, CPA | [email protected]
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For more information on this topic, please contact a member of Withum’s Cannabis Services Team.
