The immediate impact of 280E on price multiples of cannabis companies: Part II – Cannabis Business Executive

PART II:

EV/S Multiple = Enterprise Value (enterprise) / Sales (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 2, we look at Enterprise Valaue/Sales multiple  (EV/S) to help us understand the impact to firm’s valuations with and without 280E. The first step is to define and understand each variable in EV/S Multiple 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 of with and without 280E taxes.[3]

EV/S = (Market Value of Equity + Market Value of Debt – Cash)/ Sales

The first thing we do for multiples is to determine what we are evaluating; in this case it is enterprise value and then rewrite the above equation in terms that will highlight the variables impacted by 280E taxes which include Free Cash Flow to the Firm (FCFF), Weighted Average Cost of Capital (WACC), and ReInvestment Rate (RIR).

“EV” = FCFF / (WACC-g) and  “Sales” = Sales (or revenue)

And we know we can write FCFF (Free Cash Flow to the Firm) as:

FCFF = EBIT (1-t) – (CapEx – Depreciation) – Δ Working Capital

So inserting this FCFF equation into the EV formula we get:

“EV” = EBIT (1-t) *(1 – RIR) / (WACC-g)

Where EBIT = earning before interest and taxes; RIR = reinvestment rate = (CapEx – Depr – Δ WorkCap) / EBIT(1-tax)[4] ; WACC =weighted average cost of capital; g=growth rate.

We apply a bit more algebra, multiplying both sides of the EV equation by “1/Sales “(which doesn’t change the equation) and now we reframed the equation to be the EV/Sales ratio:

EV/Sales = (EBIT (1-t))*(1-RIR)/Sales / (WACC-g) * Sales

we also know (EBIT (1-t)/ sales) = After Tax Operating Margins, so we can rewrite the ratio as:

EV/Sales = After Tax Operating Margins * (1-RIR)/ (WACC-g)

At this point, we determine the EV/Sales is a function of 4 variables f(After Tax Operating Margins, RIR, WACC, g) and 280e immediately impacts 3 of the 4 variables After Tax Operating Margins, WACC (debt and equity) and RIR. Growth (g) is not immediately impacted by 280E. Based on this EV/Sales equation, Figure 3 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/Sales multiple which are low growth, low after tax operating margins, and high WACC and high RIR; where as a favorable or high EV/Sales multiple is a result of high growth, high operating margins,  and low WACC and low RIR. In 2024, with 280e, we would categorize cannabis as an industry that should have relatively low EV/Sales values.

Figure 3: EV/Sales Characteristics

Figure 4 takes our analysis one step further and shows the directional impact of the 280E variables on the numerator and denominator and the final EV/Sales Ratio. As we mentioned 3 out of the 4 variables in the EV/Sales ratio are impacted by 280E and all 3 variables immediately produce higher EV/Sales multiples.[5]

Figure 4: Impact of 280E on Numerator and Denominator and Final EV/Sales Ratio

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

Calculating the EV/Sales ratio of the simple, hypothetical model [6]using our formula derived above and is shown in Figure 5 we get a ~3.02x improvement in the EV/Sales ratio without 280E.

 Figure 5: EV/Sales = After Tax Operating Margins * (1-RIR)/ (WACC-g) [7]

 Conclusion from EV/Sales analysis

Because every company will have different absolute values for EV/Sales don’t focus on the absolute value of the ratio with/without 280E (.29 vs .87); instead understand all the variables that are part of the ratio (Figure 3), the directional impact of the 280E variables (Figure 4), and the “factor” or delta change with and without 280E in Figure 5.

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] In our simple model there is no Reinvestment Rate (RIR), so in this example it has no quantitative impact, but in reality, EV/Sales is immediately impacted by 280E because RIR has EBIT (1-t) in denominator. Because EBIT(1-t) is in denominator, if EBIT (1-t) is larger without 280E because “t” is smaller, denominator of RIR rate is larger, so RIR rate is smaller; and thus (1-RIR) is larger and is in numerator of EV/Sales. Therefore EV/Sales is higher (better) without 280. So in reality the “factor” will be even greater than reported if you consider reinvestment variables like Dep, CapEx, and Δ in working capital.

[5] It should be noted that the WACC is made up of debt and equity, and 280E impacts the cost of both debt in the form of interest rate deductions and in equity as in the beta of equity risk, so in fact we get a double benefit from 280E in WACC, but for this article we only consider it as a single variable impacted twice. The companion DCF paper has more to say on this topic.

[6] The hypothetical model is very simple with many variables held constant, as to isolate and quantify the changing variable due to tax. The actual companies will not have the same factor increases because each “real” company has different capital structures (debt/equity, preferred shares, options) and operating results (EBIT, NI, earnings) which result in different ratios.

[7] Determine multiples via the formula in Figure 5  vs  EV/Sales = (Market Value of Equity + Market Value of Debt – Cash )/ Sales  should result in similar values and both show higher/more favorable EV/Sales ratio No 280E.

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In Case You Missed It

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