Income Approach (Discount Rates) – Marijuana Businesses
Business Valuation – The Marijuana Chronicles #5
Written by: Eli C. Neal, CPA, ABV, CFF
Catch up on blog posts #1 – 4 using these links:
This post covers marijuana industry specifics in the context of the Income Approach for business valuations. The Income Approach is premised upon the concept that the value of an asset is equal to the present value of expected future benefits realized through ownership in that asset. The two most commonly used variations of this approach are the Capitalization of Future Maintainable Earnings (“FME”) Method and the Discounted Cash Flow (“DCF”) Method.
The FME Method yields a value by dividing a single-period benefit stream, defined as “Future Maintainable Earnings,” by a risk- and growth-adjusted required rate of return (the “capitalization rate”). Generally, this single-period benefit stream is estimated with reference to historical earnings or cash flows. A key assumption in this method is that the past performance of the business is indicative of future performance.
For marijuana businesses, both growers and retailers/dispensaries, it is unlikely that the company’s past performance is indicative of future performance. The industry is young, has already gone through disruptions caused by changes to local legislation, and is extremely fragmented. Most marijuana companies we talk to are projecting significant growth in future years, believing that their brand and operations will strengthen.
For these businesses that have experienced volatile historical earnings and those undergoing (or projecting) rapid growth, the maintainable earnings valuation methodology will probably not be appropriate.
For businesses where past earnings do not reflect future performance, business valuation experts will typically rely on the DCF Method. The DCF Method yields a value by projecting the future cash flows of the business over a discrete projection period, then discounting these cash flows to their present value by a risk-adjusted required rate of return (the “discount rate”).
To properly employ the DCF method, an appraiser needs to receive a projection of the company’s forecasted revenues, expenses, earnings, and cash flows. Typically, we see the DCF method being utilized with a projection period of five years but this is not a required projection period – it could be three or four years, or even longer than five years. The most important aspect of the DCF method is that the forecast used is reliable, based in reality, and thoroughly scrutinized. As valuation experts, we review and investigate whether a company’s projections can be relied upon before utilizing them in our analysis. This step is crucial, so we’ll devote the next blog post to some important areas to consider in the creation of a management forecast for a marijuana company.
For the remainder of this post, we’ll discuss discount rate considerations specific to marijuana companies as the discount rate affects both the FME and DCF methods. The discount rate takes into account the time value of money and the risk and uncertainty of future cash flows. The greater the uncertainty, the higher the discount rate, which means the lower the value.
Companies operating in the marijuana industry are players in one of the riskiest industries in the world. All of the following risks must be at least considered when valuing a business within the marijuana industry:
Competition risk – in a highly fragmented market, it is more difficult to determine winners and losers.
Regulation risk – the federal government has been a passive bystander as states have legalized medical and recreational marijuana although marijuana is still listed as a Schedule 1 drug. It is within the federal government’s power to prosecute marijuana companies and that would give any investor some pause.
Financial institution risk – I have yet to hear of a bank in Oregon accepting cash from marijuana businesses. Banks are shying away from the industry. As mentioned above, at any point the federal government could start prosecuting and take away a bank’s FDIC status. It seems extremely unlikely, but the mere threat of losing FDIC status has kept banks from extending business accounts or offering loans to marijuana businesses. Without buy-in from financial institutions, equity funds have not invested either. Marijuana businesses in Oregon are left with local angel investors as the only source of funding for the entire industry. [Note: when the banks have approval to work with marijuana businesses, we anticipate that money will flow into the industry quickly…the water is mounting behind the dam.]
Small-Company risk – generally smaller companies have shown to be riskier than larger companies and the majority of marijuana companies we’ve worked with in Portland are small in these early years.
Information access and reliability – another risk stemming from the cash nature of the industry is that it is harder to be confident in financial figures due to lack of paper trail. This risk accounts for the uncertainty concerning the reliability of underlying data.
After considering all of these risks, we’ve heard of practitioners applying marijuana company discount rates as high as 40-45 percent![1] That is compared to a typical small business having a discount rate in the range of maybe 15 – 25 percent. The higher discount rate as a huge impact on the overall value – a discount rates that’s twice as high can lead to a value that’s half as much!
For the FME method, the discount rate is typically converted into a capitalization rate (and then into a multiple). The formula for the Capitalization Rate is:
Capitalization Rate = Discount Rate Less Anticipated Long-term Growth
As we discussed above, we’ve heard of practitioners applying a discount rate of 45 percent to companies. We’ve also seen marijuana companies projecting growth of 10 percent. Plugging those variables into the above equation results in a Capitalization rate of 35 percent.
35 percent = 45 percent Less 10 percent.
Finally, a capitalization rate can then be converted to an earnings multiple by taking the inverse of the capitalization rate.
Earnings Multiple = 1 / .35 = 2.86x
This is an example of an earnings multiple that we’ve heard of for marijuana companies. Another measure we’ve also heard of is a 1x revenue multiple. The revenue multiple and earnings multiple come out to the same indicated value for companies with a 35 percent profit margin.
Investors with a high threshold for risk will see the marijuana industry as an opportunity for huge growth and potential bargains but a conservative, risk-averse investor will be wary of all the risks outlined above. As time passes, if positive trends toward full legalization continues, it’s likely that the risks and discount rate will decrease as well. When that happens, we’ll expect values to rise accordingly.
These are just a few thoughts on the Income Approach and consideration of discount rates for a marijuana business. If you’d like to know more, give us a call at 503-467-7903 and we’d be happy to have a conversation with you.
As mentioned above, the next blog post will cover specific inputs that we’ll look for in forecasts as we implement the Income Approach in the context of marijuana businesses.
[1] This is on the high end of the range. We’ve also observed discount rates for marijuana companies that are in the 15 – 25 percent range. Discount rates are company specific.