How to Value a Pot Stock

(Bloomberg Opinion) -- Cannabis growers have hardly any revenue and their product is still illegal in their most desirable market, the U.S. That’s not stopping investors and corporate giants from spending billions of dollars to take stakes in these companies. They obviously see growth potential. And yet the question remains, how do you even value a pot business? 

Altria Group Inc., the U.S. tobacco leader and maker of Marlboro cigarettes, announced in December that it was buying 45 percent of Cronos Group Inc., one of Canada’s growing number of cannabis producers and among the industry’s high-flying stocks. The $1.8 billion transaction left us wondering: How did Altria determine that price? After all, in the period before the deal, Cronos generated sales of less than $4 million – no, that’s not a typo – and certainly no profits. Recreational pot had only just become legal in Canada two months earlier. Altria, a $105 billion market-cap company that rarely does splashy deals, placed immense value on a barely existent business in a nascent market.

The dynamics were the same when Constellation Brands Inc., a beer and liquor conglomerate, spent $3.8 billion to increase its stake in Canopy Growth Corp. earlier in 2018. Canopy’s CEO has said he wants it to become the Google of pot â€“ but he’ll need to add a few more digits to its sales figures. 

It’s a tricky thing to gauge the worth of assets that will potentially be highly valuable down the road – but are difficult to quantify just yet. Looking at other industries where this has been the case is helpful. Even if their businesses aren’t perfect comparisons, the method of valuing them can be instructive. 

Take the natural-resources space, where the focus is often on non-financial metrics. They include production capacity and tangible assets, such as proved oil reserves – which is to say, how much fuel a producer can likely pump from their land. It can be argued that this is similar to how individual investors already have been gauging cannabis companies, dazzled by how many kilograms can be produced and how many acres of greenhouse they have.

But the downside to this approach for cannabis is that it puts too much emphasis on supply-chain processes that may become commoditized, and a rudimentary focus on capacity doesn’t capture how the early movers in this market can differentiate themselves. The industry’s novelty also distracts from what can be a challenging business from an operational standpoint. For example, Aphria Inc.’s share price increased more than elevenfold over the last five years, but in its latest quarter the business was hamstrung by supply shortages and packaging issues. 

A better comparison for cannabis may be the biotechnology space. Deals for drug developers involve big, risky bets on future potential blockbusters. These products may not generate revenue yet, but they aim to address very specific markets and are expected to have an economic moat that wards off competition. For pharmaceuticals, that moat comes from patent exclusivity that prevents copycat versions of a therapy. In some ways, this is what the more advanced cannabis companies are looking to accomplish. They won’t have patents in the same way, but they do aim to create intellectual property and specialized brands that appeal to certain types of customers. And they want to be first to form those customer relationships.

Remember, this market will be far more expansive than simply selling a box of joints. There’s an opportunity to create all sorts of consumer products, and the marketing can vary widely – from wellness drinks and beauty items infused with cannabidiol, or CBD (the part of cannabis that doesn’t deliver a high), to “sin” products like marijuana-infused edibles, or something more akin to having a glass of wine.

Look at it this way: Altria doesn’t own tobacco farms. It owns high-margin brands that source from tobacco growers. So when it’s studying the future of marijuana, it’s not looking solely at production. It’s looking for unique brands that can be scaled up by a team with the necessary know-how. In the case of Cronos, CEO Mike Gorenstein said on the last earnings call that the company is trying to differentiate itself with pre-rolled joints, adding that innovation around branding and efficiency will be “a bigger differentiator than just cultivation.”