A 2022 Outlook and Three Approaches to Cannabis Industry Valuations
April 18, 2022
By Hubert Klein, Jason Rice, and John O’Grady
Public and political views of medical and recreational cannabis have changed rapidly over the past year. State-licensed cannabis operations added over 100,000 new jobs in 2021 and it is estimated that the industry employs over 428,000 full-time workers. This rapid pace is the result of 37 states, four territories, and Washington D.C. supporting medical marijuana. Currently, 18 states and Washington D.C. have fully legalized the use of adult recreational marijuana.
Earlier this year, congress passed the MORE Act (Marijuana Opportunity, Reinvestment and Expungement Act of 2021). While this still has to pass the Senate and be signed into law, things are trending in a positive direction for the general acceptance and legalization of the cannabis industry in the U.S. As a result, the industry is poised for continued growth.
Along with this significant industry growth comes the issue of how to value business entities supporting the industry for various purposes including M&A transactions, financial reporting, tax compliance, regulatory compliance, and potential legal disputes. The cannabis industry is a relatively new and large sector, with medical and recreational stores accounting for approximately $18.6 billion in revenue and medical and recreational marijuana growers around $11.6 billion in revenue. This scale and age of the industry has created many questions for potential operators, investors and the general public.
Despite the difference in legality state-by-state, and on the federal level, cannabis entities are businesses with revenue and growth that need, and can be, valued like any business, with some slight adjustments.
There are three approaches to valuation; all can be used to value a cannabis business. These three approaches are as follows:
1. Asset Approach
The asset approach for valuation reviews the net asset value of the entity by subtracting the fair market value of liabilities from the assets. This approach is commonly used when it is believed that the value of the assets are the drivers as opposed to the business earnings and cash-flow stream. The two methodologies that can be used under an asset approach are:
- Net liquidation value - Values an entity as the current value of all assets and holdings. Net liquidation value reflects what your assets are worth should you liquidate everything immediately at market price.
- Net asset value - Adjusts assets and liabilities for their fair market value and the difference is determined to reach the value of the entity.
2. Income Approach
The income approach for valuation theorizes that the value of an entity is based upon expected future earnings, utilizing net cash flow projections, discount rates, and terminal values. The two methodologies that can be used under an income approach are:
- Capitalized cash flow - Determines the value of an entity by reviewing a single cash flow period that is a reasonable representation of future cash flow periods.
- Discounted cash flow - Determines the value of an entity by using projections for the earnings of the firm and discounts these projections to the present via discount rates.
3. Market Approach
The market approach for valuation considers competitors in the same industry that have similar sales and structures to the entity at hand. The two major type of market approaches used are:
- Guideline transaction method - Considers the entity at hand and compares similar entities that have been merged or acquired within range of the valuation date.
- Guideline company method - Considers the entity at hand and compares similar publicly traded entities.
Cannabis Valuation Outlook for 2022
Given that the cannabis industry in general is still in its infancy, there are some large limitation issues surrounding the valuation of cannabis businesses, including, but not limited to:
Federal Regulatory Issues
Cannabis remains illegal on the federal level and, as a result, many potential investors and operators consider it too risky for investment. This is largely a result of the federal government allowing states to self-regulate the legalization of all forms of cannabis. Currently, cannabis is listed as a Schedule I drug under the Controlled Substances Act of 1970; this is the most restrictive class, which would permit the federal government to intervene at any given time. Due to this risk, it is difficult to properly determine the ability to raise necessary capital for start-ups and as companies try to keep up with demands and potential expansions.
It is important to see where the MORE Act now goes legislatively as it awaits consideration in the U.S. Senate, and there are positive signs, if passed, President Biden will sign it into law. The MORE Act alone could significantly change the industry.
As discussed, cannabis is illegal on a federal level and legal to varying degrees by state, putting it in a limbo-state concerning taxes. In this limbo-state, IRC Sec. 280E states that all costs except for those directly linked to production, processing and storage of cannabis must be considered non-deductible items when determining taxable income, cutting into what is otherwise a relatively straightforward and profitable business. These complex tax filings also present a challenge as there are a limited number of tax professionals who are knowledgeable in this specialized space.
Rapid Industry Changes
The cannabis industry for growers, processors, and retailers, continues to be in a constant state of change to the point of being considered volatile. A major player in the field must heavily invest in licenses, technology, and time to remain relevant, especially as more states legalize and new players enter.
Lack of Market Data
Market data, as discussed above, is a key factor when determining the value of an entity. Because the industry is relatively new, there are a limited number of comparable companies and transactions to calculate market multiples. Additionally, many comparable companies are in the early stages of growth, resulting in inaccurate multiples due to the instability associated with young companies.
Dependence on Projections
Without any market data or material years of historical data for the businesses at hand, valuations will need to rely heavily upon cash flow projections. Due to this limited operating history of most cannabis companies and the unknown future of tax burdens, projections in the cannabis industry are likely to be less accurate than those of more stable and older ones.
The cannabis industry is a constantly evolving world, changing daily with new industry players, state legalizations, and technological advancements. Now that the Federal Government is moving legislation through with the MORE Act of 2021 there is another layer of uncertainty in the near term affecting the industry. Though there are risks associated with the industry, the future growth potential is enormous, making the valuation of the industry a complex matter best handled by experienced professionals.