Income Approach & Discount Rates - Cannabis Businesses (5 of 8)
Welcome to the fifth blog post in 4 Corners’ Cannabis Valuations in Washington State series! Throughout this eight-post series, we’ll be sharing information about the local cannabis industry and walking through the key concepts and challenges of a cannabis business valuation. Today's post discusses the Income Approach and discount rates.
This post covers cannabis-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 of 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 cannabis businesses, both growers and retailers/dispensaries, the company’s past performance may or may not be indicative of future performance. The industry is young, has already gone through disruptions caused by changes to local legislation, and is extremely fragmented. Many cannabis companies I’ve spoken with are projecting 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 FME 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 Discounted Cash Flow 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, I 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 a valuation expert, I always review and investigate whether a company’s projections can be relied upon before utilizing them in my analysis. This step is crucial, so I’ll devote the next blog post to some important areas to consider in the creation of a management forecast for a cannabis company.
For the remainder of this post, I’ll discuss discount rate considerations specific to cannabis 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 results in a lower value.
Companies operating in the cannabis 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 this industry:
Competition risk – In a highly fragmented market, it is more difficult to determine winners and losers.
Regulation risk – The United States federal government has been a passive bystander as states have legalized medical and recreational cannabis, although marijuana is still listed as a Schedule I controlled substance. It is within the federal government’s power to prosecute cannabis companies and that would likely give investors some pause.
Small-company risk – Generally, smaller companies have shown to be riskier than larger companies. There are some larger cannabis companies in Washington state, growing through acquisition or organic growth, but there are still a lot of standalone dispensaries and producers. The valuation community generally agrees that smaller companies are riskier because they have less capital to respond to market changes. The general fragility of smaller companies makes them riskier over a longer time horizon and less desirable to invest in.
Information access and reliability – Another risk stems from the general cash nature of the industry. Without paper trails, such as those created from credit card transactions, it is harder to be confident in a company’s financial figures. This uncertainty concerning the reliability of underlying data poses a risk to investors and the company itself.
After considering all of these risks, I’ve heard of practitioners applying cannabis company discount rates as high as 40 percent![1] Comparatively, a typical small business may warrant a discount rate in the range of 15 to 25 percent. A high discount rate has a huge impact on the overall value; a discount rate that’s twice as high can lead to cutting a value in half!
To help demonstrate how discount rates are used in practice, let’s look at a few formulas. In 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
I’ll show an example using the 40 percent discount rate used by some practitioners for cannabis companies, as mentioned above. I’ve seen some cannabis companies projecting growth of 10 percent, so we’ll use that as our anticipated long-term growth variable. Using those two variables results in a capitalization rate of 30 percent:
30 percent = 40 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 / 0.30 = 3.33x
This is an example of an earnings multiple I saw in the early days of cannabis. However, as we posted in our blog Cannabis Business Valuations are up in Washington State, the multiples have been increasing, which mathematically indicates that discount rates are falling.
Investors with a high threshold for risk will still see the cannabis industry as an attractive opportunity for huge growth and potential bargains, but a conservative, risk-averse investor will be wary of all the risks outlined above.
If you own or represent a cannabis business in Seattle, Bellevue, or elsewhere in the Pacific Northwest and need a business valuation or financial expert, call 4 Corners Financial Forensics at 425-800-4896 or schedule a video call here; we’ll listen to your situation and help you scope your project. We’d love to help you.
Stay tuned for the next blog post in this series, covering specific inputs that valuation experts look for in forecasts when implementing the Income Approach in the context of cannabis businesses.
You can find additional installments of the Cannabis Valuations in Washington State series at the links below:
[1] This is on the high end of the range. I’ve also observed discount rates for cannabis companies that are in the 15 to 25 percent range. Discount rates may vary and are company specific, just like growth rates.