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

By Lane Bruns, CEO of ICANIVEST

Executive Summary

In this 4-part series, we define and analyze the appropriate price multiples to value cannabis companies with and without 280E. In Part 1, we discuss the nuances around using price multiple ratios for cannabis company valuations. In Parts II through IV, we take a deep dive into the Enterprise Value/Sales multiple (EV/S), Price/Earnings multiple (P/E), Enterprise Value/Earnings Before Interest, Taxes, Depreciation and Amortization multiple (EV/EBITDA) respectively, identifying and quantifying how each variable in the multiple is impacted by 280E. We identify and quantify only the variables in these price comparison multiples that will be “immediately” impacted if and when cannabis is rescheduled to a schedule 3 or below drug. “Immediately” impacted variables include Free Cash Flow to Firm (FCFF), Free Cash Flow to Equity (FCFE), Weighted Average Cost of Capital (WACC (debt and equity), and After Tax Operating Margins quantified via a simple, hypothetical cannabis company (Appendix 1).[3]

We do not consider the “secondary” impacts of 280E such as increased Mergers and Acquisitions (M&A), increased Capital Expenditures (CapEx), growing revenue, refinancing debt, issuing more stock, etc.[4] because these “secondary”impacts are even more complicated and very company dependent; thus making it beyond the scope of this article.

Background

The Executive and Administrative actions by the President, Health and Human Services (HHS), and Drug Enforcement Agency (DEA) regarding the rescheduling of cannabis are substantial developments that could significantly improve the financial fundamentals and valuations of cannabis companies. There have been discussions on what rescheduling would mean for the industry, but in this article, we focus only on one aspect of rescheduling, that is the impact on cannabis companies’ price comparison multiples if the IRS 280E tax is removed. But first, some background.

Approximately 1 year after Biden requested the Health and Human Services (HHS) to look at reclassifying cannabis from a schedule 1 drug to a lower classification, the HHS gave its recommendation to reclassify cannabis as a schedule 3 drug to the DEA on Aug 31, 2023. The next step (duration unknown) is for the DEA to make its recommendation (which is also unknown) and proceed with the Formal Rule making process (public comments/lawsuits/etc) to codify the change into law. IF the DEA agrees with the HHS and successfully reclassifies cannabis as a schedule 3 or lower drug, then the punitive federal IRS 280E tax no longer applies to cannabis companies and they will no longer be required to pay taxes on gross margins but instead will pay on net income (like most every other business). 

PART I   

Introduction to price comparison multiples and the nuances associated with cannabis companies valuations

In addition to Discounted Cash Flow (DCF) models, investors often use price comparison multiples to help value a firm. There are many types of multiples which evaluate valuation, profitability, liquidity, operations, etc. but this paper focuses only on 3 “valuation” price multiples. At their core, multiples are simply ratios to standardize companies’ financials so that they can be compared across different size firms and different industries. However, multiples can be misleading and misinterpreted for the following reasons:

Multiples are myopic

A price comparison multiple is simply a ratio that describes a relationship of two numbers usually from a financial statement (but not always, think number of subscribers). It is hard to evaluate any company on just two variables so a ratio is usually very limited in scope. Furthermore, focusing on a single ratio can create a false sense of security, i.e. one multiple of a firm (actually many multiples of a firm) can be great but if just one multiple is “bad”, not considered, or ignored…it may lead to bankruptcy. In 2020/2021, MSOs in the cannabis industry had rapidly growing revenues and good EV/Sales ratios (low) for growing companies but the ratio ignores debt and tax burdens, which have subsequently crushed more than a few companies’ valuations.

Multiples are not always “standardized” even if they use the same “standardized” variable.

Multiples were created to standardize the numbers so we can compare firms in similar and dissimilar sectors/markets. By standardizing the numbers, we hope to accurately compare apples to oranges by looking at ratios not absolute numbers.  However, this can be extremely dangerous because there are often incredibly important differences between a “standardized” variable from one company and the same “standardized” variable another company. For example, in the regulated cannabis industry when EBITDA in a cannabis company is compared to EBITDA in almost every other sector (CPG, alcohol, etc,), we are ignoring/misunderstanding the structural/implied differences in the EBITDA between these two industries.  EBITDA is “earnings before interest, taxes, depreciation and amortization” but the important part for cannabis companies is “IT” because “I” (interest) is not tax deductible and “T” (taxes) are often >70%; therefore cannabis  EBITDA is much different/often less “valuable”  than other companies EBITDA where “I” (interest) is tax deductible and “T” (taxes) at ~26%[5]. It turns out many “standardized” variables in the cannabis sector are not comparable to other companies because cannabis is a federally illegal business with different tax rates, interest implications, growth rates, etc.

Multiples are relative

Analysts often use multiples to rank companies in similar sectors and allocate capital across different industries. Unfortunately, if the whole market or sector is overvalued, comparing a firm’s multiples to other overvalued firms can be painful. After the 2020 presidential elections, analysts had buy ratings on most of the cannabis stocks with the “best” multiples in the sector but failed to realize the whole sector was grossly overvalued, so even the best companies are down >70%.

Multiples are time dependent and represent just a snapshot in time

Multiples are time dependent, so you need to be consistent and understand the best time period in which to evaluate companies. Typically, multiples use numbers from the last 12 months period (called TTM = trailing twelve month), or the next/future 12 month based on forecasts (called FWD); or current period numbers like the end of a fiscal year/qtr. Unfortunately for cannabis companies all of these time periods can be tricky. TTM multiples are often not relevant because the market is so dynamic and moves so quickly that the past 12 months will look nothing like the next 12 months; accurate FWD price multiples seem reasonable but forecasts in the cannabis space are extremely difficult given the internal changes and external catalysts. We choose to update our multiples for the current period and view them only as a snapshot in time and with an eye toward how they could change in the future.

Prerequisites for multiples

As described above there are several different multiples you can calculate but it is important to understand the components of each multiple. The underlying idea is the numerator is the market price you are paying for the asset and the denominator is what you are getting for that price.

Figure 2: Consistency Requirements for Comparison Multiples:[6]

We have coined Dr. Aswath Damodaran concept of matching the numerator’s value with the denominator value as the “Consistency Rule.” As described above in Figure 2: Consistency Requirements for comparison multiples, the numerator can be a number describing market value of equity, or market value of firm (debt + equity), or market value of operating assets of a firm (EV). Whereas the denominator is what you get in return for the price which often describes revenues, earnings, cash flows, or book values. The important part is that you are consistent with the values in the numerator and denominator. If the numerator is market equity value, then denominator has to be a market equity value; if the numerator is an enterprise value, then the denominator has to be an enterprise value.  In early stage/growth cannabis companies, analysts often use ratios that break the consistency rule like Price (equity) / Sales (enterprise) & Price (equity)/ EBITDA (enterprise) because they are easily attainable, and the ratio seems to be easily understood. Unfortunately, the numerator, “price”, is price of an equity share (equity), and the denominator is sales, “revenue” of the company (enterprise) and so breaks the consistency rule. Cannabis analysts also used Price/EBITDA multiple to widen the view of the companies by including operating performance by incorporating EBITDA. Again, it is simple but incorrect, as it violates the consistency rule because Price of share (equity in numerator) and EBITDA (EV in denominator).

Next up

Part II of this series will cover The Enterprise Value (enterprise) / Sales (enterprise) Multiple.

Disclaimer:

Although price multiples valuations are extremely important, no model/ratio can 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. 

Appendix 1 – Financials of simple hypothetical cannabis company

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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] The hypothetical model is very simple, holding many variable consistent, as to isolate and quantify the changing variable due to tax. Actual companies will not have the same factor increases because each “real” company has a different capital structure (debt/equity, preferred shares, options) and operating results (EBIT, NI, earnings) which result in different results.

[4] It could be argued that the secondary impacts of removing 280e will be more impactful on cannabis company valuations than the immediate impacts.

[5] For simplicity using 22% federal + 4% state.

[6] Dr. Aswath Damodaran’s work at NYU