In the first two parts of this series(Click here for Part I, and here for Part II) we laid a foundation for business and intellectual property appraisal in the cannabis sector and considered the income approach to value and how to apply it to marijuana ownership interests.
In this installment, we will take a deeper dive into the use and application of the market approach to value, including an emphasis on finding and analyzing market data from prior transactions of similar ownership interests. We will look at how industry market data is located, assessed, adjusted and applied to marijuana ownership interests, including interests in intellectual property such as license rights for cultivation, processing and retailing facilities.
A difficult task
Valuing any early-stage company in an emerging industry is a difficult task, and we would argue that valuing an early-stage enterprise in the cannabis and hemp sectors is even more difficult due to a lack of regulatory and legislative consistency between jurisdictions, as well as the lack of historical context within an extremely dynamic industry sector. (While this discussion is focused primarily on using the market approach to value cannabis-related interests, much of the content is also applicable to the valuation of agricultural hemp and CBD-related interests.)
Early-stage valuation relies almost entirely on assumptions, or put another way, best guesses about future growth and related product pricing and cost structures. Making predictions about more mature cannabis or hemp-focused companies isn’t easy either, due to rapidly evolving economic, technological and regulatory dynamics. The direct and indirect impact of the COVID pandemic and associated rounds of economic stimulus on this sector are prime examples.
We believe any method used to value a cannabis or hemp company results in a best-effort guess, which could prove to be drastically different than the reality of how the business actually unfolds in such a fast-changing landscape. After all, analysts and investors are not fortune tellers. This dynamic is even more pronounced in the cannabis realm, an area of polarized opinions and market prognostications clouded by euphoric undertones that has whipsawed the share price of public-facing companies in this sector during the last few years. Uncertainty abounds, as do potentially unrealistic expectations.
Moreover, unprecedented growth in private capital markets and accommodative fiscal policies over the last several decades have tilted the scales in favor of “hot” emerging growth opportunities, as investors have become “yield starved” and in search of more meaningful returns. In fact, private market multiples (based on EBITDA) exceed that of the public sector, a phenomenon that has only occurred two other times in history — during the “Barbarians at the Gate” era of the mid-1980s and during the exuberant run-up to the great recession, according to Bain Capital’s 2019 Global Private Equity Report — both of which were followed by market collapses.
When put in context, it’s rational to believe there is a systemic bias toward heightened valuations of growth assets in the current economic environment. Warning signs have been flashing in the IPO market as companies like WeWork, Uber and Lyft have been prevented or penalized for “going public” at wildly optimistic market caps without being profitable.
Paraphrasing what Alan Greenspan, former chairman of the Federal Reserve Bank, said in a December 1996 speech, “there appears to be some irrational exuberance in the markets.” We believe this must be taken into consideration when assessing the reliability of market multiples in this space.
The ‘rule of thumb’
On the other hand, cannabis represents one of, if not the, fastest growing industries in the world and therefore overly pessimistic forecasts do valuations in this space no justice either. Further, it is an industry that is both hindered and protected by unique and substantial regulatory hurdles.
A discussion of the market approach to value in the cannabis sector would not be complete without reference to the 1X top-line revenue multiple as a “rule of thumb” so many have tried to use to estimate the value of an enterprise in the sector. It is a dangerous metric for sure, but still provides a starting place, particularly for a license or entity that has begun to generate some level of economic return.
As one operator in the California cannabis industry explained to us when we asked about the company’s valuation policy for cannabis assets, “1X sales is the starting point which assumes the business can achieve a 20% EBITDA margin.” When analyzed further, the 1X sales multiple “rule of thumb” in this industry appears to be consistent with the median 5X EBITDA multiple that private companies across all industries transacted for within the DealStats coverage universe in Q4 of 2020.
According to DealStats, a company which collects data on private company transactions, the average selling price to earnings before interest, taxes, depreciation and amortization (P/EBITDA) among all industries it covers was 5.1X EBITDA in Q4 of 2020. To be clear, the profit potential of cannabis companies can vary drastically by state and the long-term sustainability of profits in this business are uncertain with so many moving pieces, but the 1X sales multiple, while appearing overly simplistic, seems to be grounded in an achievable narrative, given that many cannabis businesses have obtained a 20% or higher EBITDA margin.
Like any industry, results vary widely among operators, and profits are anything but a foregone conclusion.
Valuation science requires a deeper dive into the projected growth and stability of such revenues and, more importantly, the focus on bottom-line economic returns to investors to get a more reliable sense of value. Rather than relying too heavily on the 1X sales multiple, we build custom “comp” tables for each market in which we are valuing a cannabis asset (if enough data can be found). We will locate press releases with valuation insights, interview cannabis business and real estate brokers, scan public securities filings of companies that have transacted in markets that we are interested in and directly interview operators of cannabis businesses to gain as many data points as possible for our valuations.
From this research, we have built custom guideline company transaction tables that help inform our overall valuation approach for each engagement. However, this is a tedious and time-consuming process that, in our opinion, is essential to understanding the value of a cannabis asset.
More industry-specific market data is becoming accessible to assist business and intellectual property appraisers, including transactional data from completed merger and acquisition activity that is captured by reputable databases, including DealStats and MJResearch. In addition, our firm has captured and compiled a growing inventory of license rights valuation information, primarily from publicly traded company disclosures on acquired licenses and related intellectual property assets. We now have information on more than 50 transactions involving license rights acquisitions.