How do you value a cannabis company with no earnings or revenue?

Investors should take rational approach to pot mania, Martin Pelletier advises.

It has been nothing short of amazing to watch what has been transpiring in the cannabis sector in recent months, with the volatility and sky-high valuations bringing a dose of excitement to the resource heavy Canadian equity market.

Interestingly, this euphoria has now spread south of the border with Americans rushing to get in on the action as well.

Take a look at Tilray Inc., for example, which saw its share price nearly double after being featured on Jim Cramer’s Mad Money last Tuesday before settling back to an $11-billion valuation to end the week — still not bad for a company that posted only $20 million of revenue in the first half of the year.

The closest thing to the ongoing mania that I’ve seen up close during my career — albeit at a much smaller magnitude — would be what transpired with the oil-and-gas income trust and exploreco market back in the early 2000s, when peak oil was all the rage.

Back then, income trusts were being created out of mature energy companies with a junior exploreco being spun out at the same time, often at a ridiculous valuation. This worked exceptionally well — especially for management teams who loaded up on exploreco shares — as long as analysts kept providing high target multiples and investors kept paying up, often at three to five times the company’s net asset value.

In particular, I remember one exploreco that was set up as a blind pool, only to have a sellside analyst launch research coverage by giving the all-cash company a target multiple on its cash position. The title of the report was: “When cash is worth more than cash.”

On one occasion, I launched coverage on an exploreco with a healthy target multiple of two times net asset value, which just so happened to be below the price at which it began trading. All was fine until I received a nasty phone call from an irate president yelling at me for failing to match other analysts’ much higher targets.

In response, I told him that if he could walk me through how his $50-million capital program would unlock $250 million in additional value, I would give him a target more in line with the other analysts.

Needless to say, it was a short conversation.

While the legitimate market potential for cannabis looks to be substantially greater than in the case of those explorecos, I would like to think a similar rational approach to valuing the sector should apply — beginning by asking how each company will unlock both its implied and forecasted values.

Overall, after reading a number of reports, we believe the current valuation of the industry as a whole is too high given its early stage and the number of variables at play. These include the potential for overestimating demand and pricing while underestimating the supply response. Even after the Canadian marketplace is established there will be big unknowns, such as just how large and accessible international markets will be — something that will be key for those producers with excess supply.

Nonetheless the rush is on, with investors and speculators sending company share prices skyrocketing. According to our calculations, the sector has a whopping market value of approximately $50 billion (or more than $70 billion when including international companies) resulting in an implied 7 to 8 times multiple on a forecasted $6 billion to $7 billion in Canadian revenue and a 50 times multiple on the expected $1 billion of EBITDA by 2020.

Such multiples do not mean that every company in the sector is overvalued, but we think the number of losers will surely eclipse the number of winners. Separating the two is the challenge, as there are more than 120 marijuana companies listed on the Canadian stock exchanges, according to a recent Wall Street Journal analysis.

That said, we think the place to start is by focusing in on two main questions: Who will have first-mover advantage with instant scalability; and, on the production side, who will be the lowest-cost producer.

Once the field is narrowed down, one can try to estimate the percentage of market share required to backstop a specific company’s current and projected valuations.

A word of warning, though: Assessing the valuation of a company in a fledgling industry that has virtually no revenue or earnings is no easy feat, even for us investment pros.

That’s something retail investors should keep in mind amid the current mania. Financial Post Martin Pelletier, CFA, is a portfolio manager and OCIO at TriVest Wealth Counsel Ltd, a Calgarybased private client and institutional investment firm specializing in discretionary risk-managed portfolios as well as investment audit and oversight services.