# Financial valuation methods for cannabis companies

If you are a cannabis entrepreneur trying to raise money, it’s important to understand the different valuation methodologies that investors are familiar with. Here I will walk you through the three main methods most commonly used and explain how they relate to each other.

**1. The DCF valuation**

The DCF valuation (or Discounted Cash Flow) looks at the future cash flows that will be generated by the company and assesses the net present value of that cash today.

The important terms for this valuation methodology are: **free cash flow**, **discount rate**, and **terminal growth rate**.

To begin, we start with the company’s projected **free cash flow**: this is the cash that will be generated by the business after all business expenses have been paid. The free cash flow is different from sales, because it considers the company’s future expenses. It is also different from the net income, because it considers capital expenses (cash expenses investments in assets that are not included in the net income) but adds back depreciation expenses (since they do not represent actual cash expenses). It also considers the working capital requirements (the cash the company will need to meet its day to day financial obligations) which are not reflected in the net income.

We project the free cash flow over a period of five years, and then use the **terminal growth rate** to calculate a terminal value which represents all projections beyond the five-year period. For a conservative approach, use a 0% rate.

The projections are then discounted back to today’s value, to represent the time value of money. $100 today is worth more than $100 in one year, because it can be invested today and yield $110 in one year. This assumes an average investment return rate of 10%.

If $100 today is worth $110 in one year, then $110 in one year is worth $100 today. The discount rate of future money to calculate its net worth today is 10%.

Expected return rates and **discount rates** go hand in hand. The discount rate represents the average cost of capital for the company, and when most of the capital comes from investors, the discount rate represents the investors’ expected return. Expected is the key term here. For large stable companies, the risk is lower so investors expect lower returns. For small start up companies, the risk is higher so investors expect higher returns. For cannabis companies, the discount rate can vary wildly, but 30% is usually considered a good starting point.

Once you have the projected free cash flow, the discount rate and the terminal growth rate, you can calculate the discounted cash flow valuation of the company. This valuation method is closest to the core operating requirements of the company, and a good starting point for a current valuation of the company.

**2. The multiples valuation**

The multiples valuation looks at different projections for the company (most typically Sales and EBITDA) and applies a multiple to them. For example, if sales are $10M and the sales multiple is 2.0x, the company’s valuation is $20M. This method is helpful for determining the value of a company today, but also for determining the potential value at a future date.

The important terms for this valuation are the multiple, the number that is being multiplied, and the annualized period that number belongs to.

Multiples can vary drastically. Currently, some cannabis companies are being traded on the Canadian market for 100 x sales. Private companies in the US are raising money from private investors with multiples that vary from 1 x sales to over 10 x sales. Choosing the right multiple is as much of an art as a science, especially in a market as young as the cannabis market. The comparables valuations will touch more on how to choose the right multiple.

**LTM Sales, NTM Sales, 2020 Sales and beyond**

The sales multiple looks at the projected sales for the company, often called the “top line” because sales is the first line on the income statement. Because the sales projections are the highest number projected (no expenses have been deducted yet), the sales multiple is always the lowest multiple.

The multiple can be applied to the LTM sales (last twelve months), which are historical, actual figures. It can also be applied to the NTM sales (next twelve months), or any future year’s sales, which are all projected, estimated figures.

For example, if the company made $1M in revenue last year and is projected to make $2M in revenue the next year, a 2.0x LTM sales multiple shows a $2M valuation, but a 2.0x NTM sales multiple shows a $4M valuation. This gives a good idea for a current valuation range for the company.

Multiples valuations are also helpful to calculate projected returns for investors. If the company is worth $4M today and is projected to reach $10M in sales in 2020, then using the same 2.0x multiple, it will be worth $20M in 2020. Therefore, investors investing today stand to make a high return if the company meets is projections, based on the same 2.0 x sales multiple.

**EBITDA multiples**

EBITDA multiples follow the same logic as the sales multiples but are based on the EBITDA which represents Earnings Before Interests, Taxes, Depreciation and Amortization. It is basically the operating income of the business. This valuation provides a more accurate reflection of the company’s value, because it requires the company to be profitable, at least on an operational level, for the valuation to be positive. EBITDA multiples are higher than sales multiples because they are based off a much smaller number.

The multiples valuations work best hand in hand: a 2.0x sales multiple and a 8.0x EBITDA multiple will provide two data points that help investors think about the current and future value potential of the business.

**3. The comparables valuation**

The comparables valuation looks at the public valuation multiples of comparable companies (comps), or the valuation multiples used for the acquisition of a comparable company (compacqs).

This method is not as commonly used in the cannabis industry because of the lack of accessible information. Other than the Canadian stock market, there is no source for comparable public valuations. And because most acquisitions in this space are private, it can be difficult to access that information as well.

The next best option is to think about companies that are in different industries but comparable in nature (size, products, growth stage), to draw from their publicly available information.

When comparables are available, they provide a good source for choosing a multiple: by looking at the multiples applied to similar companies, we deduct a range and an average multiple that we can then apply to our own company.

In conclusion, when pitching investors, be sure to understand the different ways your company’s valuation can be justified and the related assumptions. By combining the different valuation methodologies and triangulating their outcomes, you will be able to provide a strong case for a valuation range that will speak clearly to investors.