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Cannabis in Canada: 7 Factors to Know When Considering Where to Invest in the New Market

Cannabis in Canada: 7 Factors to Know When Considering Where to Invest in the New Market

Determining the value of a business in an evolving market is always tricky. When that market has only recently been legalized? Even trickier. But it can be done.

L

ast October, Canada joined Uruguay as one of only two countries in the world to legalize the use of recreational marijuana nationwide. But Canada stands apart; its strong agricultural infrastructure positions it to be a leader in supply and to capture a significant share of global sales predicted to range from $70 billion to $150 billion by 2024.

Many Canadian cannabis companies are already actively pursuing growth through acquisition, which has placed increased emphasis on the importance of business valuations in the sector. But determining valuation in a nascent industry is a challenge. And when that industry has only recently become legal it can be a real puzzle. Multiple complexities exist, including uncertainties around industry fundamentals, the regulatory environment and a lack of historical financial data.

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Traditional valuation multiples have proven less meaningful or reliable in the current expansionary phase. For instance, Canada’s medical marijuana industry (legal since 2001) might seem to offer a comparable market-based approach, but these companies are still in the growth stage and generally not yet profitable. Looking toward more mature markets that are similarly regulated (tobacco and alcohol) is also deficient. Future valuation benchmarks for cannabis companies far exceed those of tobacco and alcohol.

With recreational cannabis companies experiencing high revenues and widespread operational losses, expected future cash flow analysis is emerging as a primary factor for valuation with certain risks (regulation, agricultural interruptions, consolidations) incorporated into the valuation. Added to this are the opportunity costs associated with the passage of time. This leads to a discounted cash flow (DCF) analysis.

The DCF approach forecasts future operation cash flows for a number of years and discounts these to a present value. Once a company reaches maturity and expected cash flows are stable, a terminal value can be calculated and discounted to a present value, which is added to discrete cash flows from earlier years. The DCF approach thus allows for modeling the impact of a range of possible scenarios over several years as the industry matures and stabilizes.

For investors eyeing Canada’s cannabis market, the following seven factors play major roles in determining discounted cash flows. (And can also be taken into account when applying alternative valuation approaches.)

1. Size of the Market
Uncertainty exists around the size of the overall cannabis market. A surge in demand is expected through attracting new customers, shifting sales from the illegal market and the introduction of new products. However, the lack of historical operations in the industry results in uncertainty in demand and the overall size and growth of the market.

2. Obtaining a License
Companies are required to obtain a license from Health Canada to operate in the industry. It is a time-consuming process that could impact a company’s ability to operate and generate revenue.

3. A Range of Pricing
Provinces and territories regulate pricing and distribution of the product. Some provinces allow private retailers to sell cannabis, while others are controlled by the federal government. Either way, pricing will be a key factor in shifting demand to the legal market. In order to encourage consumers to purchase cannabis from legal channels, prices must be competitive with the illegal market.

4. Cost of Goods
Cannabis companies are capital intensive at the initial stages of the business, requiring specialized and large-scale agriculture facilities. Companies will also be faced with high operating costs as they scale up production to meet growing demand. Regulations will have an impact on operating costs including requirements for packaging, product testing, etc. High operating costs will put pressure on operating margins, which need to be considered when forecasting cash flows.

5. Access to Funding
Despite legalization of cannabis, companies in the industry have a high risk profile. As a result, they may have difficulty obtaining access to capital. In such a capital-intensive industry, a lack of funding could pose a risk to a company's operations and expected growth.

6. Products and Branding
The introduction of new products to the market will have a large impact on growth for cannabis companies. Currently, legal products in Canada include dried flowers, pre-rolls, capsules and oils. Tremendous opportunity exists for companies to expand their product offering with edibles; however, that is largely dependent on the government’s upcoming plans for legalization, the timing of which is uncertain. Additional uncertainty exists around the impact of branding on sales. Cannabis is considered a commodity, and while the market is in its infancy, the importance and the impact of branding remain uncertain on consumer purchasing decisions.

7. Management Experience
An experienced management team is critical to a company’s success as they set the overall strategic direction of the business. It will be important to assess the strength of management, particularly given that many companies in the cannabis industry are early-stage businesses with a management team that may not have a proven track record.

Companies in Canada’s cannabis industry are responding by pursuing various acquisitions, strategic partnerships and organic expansion initiatives to protect and grow their share of the market. Acting quickly while the market is just out of the gate offers numerous advantages for investors.

For more about implied multiples in Canada’s top 20 largest cannabis companies, plus other details on discounted cash flow analysis, see the FTI white paper “Cannabis: Valuation Approaches in an Evolving Market.”

Published May 2019

© Copyright 2019. The views expressed herein are those of the authors and do not necessarily represent the views of FTI Consulting, Inc. or its other professionals.

About The Authors


Neal Mizrahi
neal.mizrahi@fticonsulting.com
Senior Managing Director
Economic & Financial Consulting
FTI Consulting

Natalie Quinn
natalie.quinn@fticonsulting.com
Senior Director
Economic & Financial Consulting
FTI Consulting

Sheri Herblum
sheri.herblum@fticonsulting.com
Senior Consultant
Economic & Financial Consulting
FTI Consulting

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The Economic Consulting practice at FTI Consulting provides sophisticated and comprehensible analyses of complex economic, financial and accounting issues. We provide critical insight and expert testimony in legal and regulatory proceedings, and expertise in antitrust issues, mergers and acquisitions, securities litigation and risk management, valuation and international arbitration.
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