How do we look at cannabis companies' cash flow? What is their total value and what methods are used to assess their worth?

A new report from Viridian Capital Advisors sheds light on how these factors interact to influence the valuations of public cannabis companies by analyzing cash flow, market capitalization and valuation metrics.

Why It Matters?

These indicators are crucial for evaluating the financial health and market position of cannabis companies and determining the potential of their stocks. For instance, cash flow analysis can show a company's ability to meet short-term obligations.

Meanwhile, market capitalization represents a company's total market value, signaling its size and stability. Additionally, valuation metrics, such as the price-to-earnings ratio, help evaluate whether a stock is priced appropriately relative to its earnings.

Liquidity And Valuation Correlations

Viridian categorizes twenty U.S. cannabis companies into two groups based on market capitalization: those under $500 million and those above.

Within each group, companies are further segmented into quartiles based on a specialized liquidity measure — the free cash flow adjusted current ratio.

The findings highlight a distinct correlation between liquidity and valuation metrics, notably the Enterprise Value to consensus 2024 EBITDA estimates.

For companies under $500 million, the median EV/EBITDA ratio stands at 6.16x. This ratio ascends as liquidity increases, supporting the hypothesis that higher liquidity correlates with higher valuation metrics due to perceived lower risks of needing near-term capital.

A Shift In Larger Cap Companies

In the segment of companies with a market cap over $500 million, the trend inverts. Here, the median EV/EBITDA ratio is 8.86x, which unexpectedly decreases as liquidity increases.

This reverse correlation suggests that in larger companies, increased liquidity might not always signify a safer investment.

Historical data from Viridian’s Chart of the Week on January 24, 2021, corroborates this finding, showing large-cap groups trading at over 20x the next twelve months (NTM) EBITDA during periods of high liquidity.

While smaller companies benefit from increased liquidity in terms of valuation, larger companies exhibit a more nuanced relationship where more liquidity can be associated with lower valuation metrics.

The paradox here lies in the unexpected reversal of traditional valuation trends related to cash flow. Typically, higher liquidity is associated with higher valuation metrics, indicating lower perceived risks.

However, in the case of larger cannabis companies, increased liquidity seems to correlate with lower valuation metrics, contradicting conventional expectations. This paradox, notes Viridian, challenges investors to reevaluate their assumptions and underscores the complexity of assessing investment opportunities within the cannabis sector.

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