The immediate impact of 280E on price multiples of cannabis companies: Part IV [1][2] – Cannabis Business Executive

By Lane Bruns, CEO of ICANIVEST

PART IV: EV/EBITDA Multiple = Enterprise Value(enterprise) /Earnings before Interest Taxes Depreciation and Amortization (enterprise)

Recall that the removal of 280E means cannabis companies stop paying taxes on gross margins and start paying taxes on net income, effectively reducing tax rate anywhere from ~70% to ~26%. (exact tax rate varies from company to company). In part 4, we look at EV/EBITDA multiple to help us understand the impact to firm’s valuations with and without 280E. The first step is to define and understand each variable and determine what effects 280E has on those variables. This is harder than you think, because you need to deconstruct the formulas to understand the impact of a changing tax rate on multiples. Once we know which variables/values are impacted, we quantify the impact and show an example with and without 280E tax rate[3]

EV/EBITDA = (Market Value of equity + Market Value of Debt – Cash ) / Earnings before interest, taxes, depreciation and appreciation

The first thing we do for multiples is to determine what we are evaluating, in the case of EV/EBITDA  both are enterprise values (not equity as in the P/E multiple); and so we rewrite the above equation in terms that will highlight the variables impacted by 280E taxes which include Free Cash Flow to the Firm (FCFF) and Weighted Average Cost of Capital (WACC). To keep the algebra simple, we use a single stage valuation model for value of the firm (switching back from FCFE to FCFF):

EV = FCFF/(WACC-g)

However, we need to define EV in a slightly different way than we did in the EV/Sales equation because we need to isolate EBITDA in this ratio, so:

FCFF = EBITDA(1-t) + Dep (t) – Cap Ex – + Δ WorkCap and to make it even simpler we use the variable defined above in EV/Sales for RIR[4]. So we can rewrite equation:

FCFF = EBITDA (1-t) +(1- RIR)

EV = (EBITDA (1-t) +(1-RIR)) / (WACC-g)

We apply a bit of basic algebra, multiplying both sides of the EV equation by EBITDA  (which doesn’t change the equation) and now:

EV/EBITDA = ((EBITDA(1-t)+(1- RIR))/ (WACC – g) )/ EBITDA

Which gives us the final equation we can work with for this ratio:

EV/EBITDA = (1-t)/WACC – g) + ((1-RIR)/EBITDA)/(WACC-g))

At this point we can determine the EV/EBITDA ratio is a function of 5 variables f(tax rate, EBITDA,  WACC, RIR, g) and 280E immediately impacts  3 of 5 variables  (t=tax rate, and WACC (debt and equity), RIR ); where as 280E does not immediately impact EBITDA and Growth (g). Based on the above equation, Figure 9 shows directionally how the variables of the equation impact the outcome of the ratio. In this case the column in red defines the characteristics of an unfavorable or low EV/EBITDA multiple which are low growth, low EDITDA, high WACC, high tax rate, and high RIR; where as a favorable or high EV/EBITDA multiple is a result of low tax rate, high growth, high EBITDA, low RIR, and low WACC.  In 2024, with 280E, we would categorize cannabis as an industry that should have relatively low EV/EBITDA ratio.

Figure 9: EV/EBIDTA Characteristics

Figure 10 takes it one step further and shows the relationship of the 280E impacted variables in the numerator and denominator and the change they cause in the EV/EBITDA ratio. As you can see, variables impacted by 280E produce a Higher EV/EBITA Multiples.

Figure 10: Impact 280E has on Numerator and Denominator and Final EV/EBITDA Ratio

Example of impact to EV/EBIDTA with and without 280E

Calculating the EV/EBITA ratio of the simple, hypothetical model using our Figure 11 formula [5] of EV/EBITDA,  we get a factor increase of 3.01x improvement in EV/EBITDA without 280E.

Figure 11: EV/EBITDA = (1-t)/WACC – g) + (RIR)/EBITDA/WACC-g)

Conclusion of EV/EBITDA analysis

Because every company will have different absolute values  for EV/EBITDA multiple, don’t focus on the absolute value of the ratio pre/No 280E (1.44 vs 4.34); instead understand all the variables that are part of the ratio (Figure 9), the directional impact of the 280E variables (Figure 10), and the “factor” or delta change with and without 280E in Figure 11.

Conclusion

This article defines the price multiples in a discounted cash flow variable construct of risk, growth, FCFF. FCFE and WACC.[6] We used a simple hypothetical company to give quantitative examples of how each of the price multiples are immediately impacted by eliminating the 280E tax. The results in Figure 12 confirm that tax rate is an incredibly critical component in computing company valuation multiples because the tax rate significantly impacts so many of the price multiple’s variables.

Figure 12: Results

Next Steps

At ICANIVEST we have taken the next step and applied the same logic to existing cannabis companies with actual numbers from their financial reports to calculate their price multiples and their expected “factor increase” with and without 280E. Although all the multiples show positive factors increasing the multiple,  depending on the company’s capital structure and operating results, the multiple can be higher or lower than our hypothetical company described in this article/example. Perhaps even more importantly, we have add to the above analysis our best understanding of what impacts removing 280E will do to the valuations of actual companies by modeling in secondary impacts of a reduced tax rate.  Specifically, we modeled in the changes to growth rates, debt costs, different capital structures, changing beta, issuing more stock, etc to try and tell the full story of how the removal of 280e will impact each individual cannabis company’s valuation in the long term.

Disclaimer:

Although DCF valuations are extremely important, no models fully represent/predict company valuations. Market valuations are notoriously complex and fickle and may have already incorporated all or some of the benefits of both the immediate and secondary effects of 280e into the current market price and valuation multiples.  ICANIVEST, LLC does not make any representations or warranties as to the accuracy, timeliness, suitability, completeness, or relevance of any information. All such information is provided solely for convenience purposes only and all users thereof should be guided accordingly. Investments involve risk and unless otherwise stated, are not guaranteed.  Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy.  This information is not intended to provide investment, tax, or legal advice. 

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[1] This is a companion article to “The immediate impact to 280E on cannabis firm’s DCF valuations.”

[2] The article borrows heavily from Dr. Aswath Damodaran’s work at NYU. ICANIVEST, LLC investment strategy is also based on Dr. Damodaran’s framework of valuation. Please find his work at https://pages.stern.nyu.edu/~adamodar/  

[3] .  As a reminder, just like our DCF valuation model, we don’t look at “secondary” effects on price comparison multiples but only the “immediate” impact to price multiples if 280e is removed.

[4] RIR = reinvestment rate = (DA – CapEx -+ Δ WorkCap)/EBIT(1-tax)

[5] Defining multiples via the discount cash flow or the comparative/relative construct should result in similar values and as expected both show that the EV/Sale ratio is higher (more favorable) without 280E.

[6] Although a relative or comparable variable construct using common financial variables like operating income, taxes, net income, market cap, debt, equity, etc will result in the same answers.

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In Case You Missed It

The immediate impact of 280E on price multiples of cannabis companies: PART I

The immediate impact of 280E on price multiples of cannabis companies: PART II

The immediate impact of 280E on price multiples of cannabis companies: PART III