Tips for analyzing pot stock valuations

Why cannabis investments aren’t for the faint of heart

Canada became the first G20 country to legalize cannabis for recreational use on Wednesday (and the second in the world, joining Uruguay). As such, “an unprecedented opportunity exists” to shape the regulatory framework for cannabis worldwide, says an EY report, and to spur innovation and economic activity. In particular, transparent and robust valuations will be important for companies to succeed.

As the industry evolves, “businesses and investors will need to revisit valuation fundamentals to avoid overpaying for assets,” says the report. “Entrepreneurs who are founding members of cannabis businesses will need to do the same to avoid leaving money on the table.”

Right now, valuations may look extremely high because historical results reflect only medical cannabis use.

“A key valuation principle is that value is based on future cash flows (historical ones may be useful as a guide),” says the report. “The future for a cannabis business is likely going to be dramatically different from its past.”

Along with expected future cash flows, operational statistics can help explain valuations, such as types of licences and the number of employees and their equity in the business.

The report also says that, with the industry in its infancy, investors will require high returns on capital.

“This investment journey is not for the faint of heart,” it says. “Required returns (and therefore valuation discount rates) will need to be high enough to reflect the risks investors face at the particular valuation date.”

John Christofilos, senior vice-president and head trader at AGF Investments, cautions against cannabis companies, likening current valuations to an earlier bubble.

“While many of these stocks could end up being legitimate investments longer term, this hyped-up period of marijuana-mania—characterized by wild price swings, market halts and outsized valuations—has a striking resemblance to the unsustainable dot.com frenzy of two decades ago and should be cause for caution,” he wrote in an Oct. 15 blog post.

For market capitalization of the 25 largest Canadian public companies in the cannabis industry, as well as recent transactions in the cannabis space, see the full EY report.