By Lane Bruns, CEO of ICANIVEST

PART III:   Price/Earning Multiple  = Market Cap (equity)/ Earnings (equity)

Recall that the removal of 280E means cannabis companies stop paying taxes on gross margins and start paying taxes on net income, effectively reducing tax rate anywhere from ~70% to ~26%. (exact tax rate varies from company to company). In part 3, we look at the Price/Earnings multiple (P/E) to help us understand the impact to firm’s valuations with and without 280E. The first step is to define and understand each variable in the P/E Multiple and determine what effects 280E has on those variables. This is harder than you think, because you need to deconstruct the formulas to understand the impact of a changing tax rate on multiples. Once we know which variables/values are impacted, we quantify the impact and show an example of with and without 280E taxes.[3]

P/E = Price/Earning = Market Cap/ Net Income (or on a per share basis)

The first thing we do for multiples is to determine what we are evaluating, in this case equity values (not enterprise value as in EV/Sales multiple); and so we rewrite the above equation in terms that will highlight the variables impacted by 280E taxes which include Free Cash Flow to Equity (FCFE) and Cost of Equity (r). To keep the algebra simple, we use a single stage valuation model for Equity (Notice FCFE not FCFF):

Price(value of equity) = FCFE/ r-g

We apply basic algebra and multiple each side of the equation by 1/earnings  (doesn’t change equation) and now we can reframe the Price / Earnings ratio as:

            Price/Earnings = (FCFE / Earnings) /(r-g)

At this point we can determine the P/E ratio is a function of 4 variables f(g=growth, r= cost of equity, FCFE, earnings) and 280e immediately impacts 3 of the 4 variables –  FCFE, earnings (net income), r=cost of equity. Growth (g) is not directly impacted by 280E. Based on the P/E equation, Figure 6 shows directionally how all the variables of the equation impact the outcome of the ratio. In this case the red column defines the characteristics of an unfavorable or low P/E multiple which are low growth, low earnings, high cost of equity, and low FCFE; whereas the green column shows the characteristics of a favorable or high P/E  multiple which is a result of high growth, high earnings,  and low cost of equity, and high FCFE.  In 2024, with 280E, we would categorize cannabis as an industry that should have a relatively low P/E.

Figure 6: P/E Characteristics

Figure 7 takes our analysis one step further and shows the directional impact of the 280E variables on the numerator and denominator and the final P/E Ratio. As you can see, 2 variables make the P/E ratio higher and 1 variable (earnings) makes P/E lower.

Figure 7: Impact of 280E on Numerator and Denominator and Final P/E ratio

 Example of impact to Price/Earnings with and without 280E

Calculating the P/E ratio of the simple, hypothetical model using our discounted cash flow formula [4] of P/E we derived above and is shown again in Figure 8, we get a 3.06x improvement in P/E No 280E.

Figure 8: P/E  = (FCFE/Earnings)/(r-g)

 Conclusion from P/E analysis

Because every company will have different absolute values for P/E don’t focus on the absolute value of the ratio with and without 280E (1.81 vs 5.55); instead understand all the variables that are part of the ratio (Figure 6), the directional impact of the 280e variables (Figure 7), and the “factor” or delta change with and without 280E in Figure 8.

Disclaimer:

Although DCF valuations are extremely important, no models fully represent/predict company valuations. Market valuations are notoriously complex and fickle and may have already incorporated all or some of the benefits of both the immediate and secondary effects of 280e into the current market price and valuation multiples.  ICANIVEST, LLC does not make any representations or warranties as to the accuracy, timeliness, suitability, completeness, or relevance of any information. All such information is provided solely for convenience purposes only and all users thereof should be guided accordingly. Investments involve risk and unless otherwise stated, are not guaranteed.  Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy.  This information is not intended to provide investment, tax, or legal advice. 

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[1] This is a companion article to “ The immediate impact to 280E on cannabis firm’s DCF valuations.”

[2] The article borrows heavily from Dr. Aswath Damodaran’s work at NYU. ICANIVEST, LLC investment strategy is also based on Dr. Damodaran’s framework of valuation. Please find his work at https://pages.stern.nyu.edu/~adamodar/

[3] .  As a reminder, just like our DCF valuation model, we don’t look at “secondary” effects on price comparison multiples but only the “immediate” impact to price multiples if 280e is removed.

[4] Determine multiples via the P/E=(FCFE / Earnings) /(r-g) or  P/E=Price of stock/ earnings per share should result in similar values and as expected both show that the P/E ratio is higher (more favorable) No 280E.

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In Case You Missed It

The immediate impact of 280E on price multiples of cannabis companies: PART I

The immediate impact of 280E on price multiples of cannabis companies: PART II