< PreviousA PROFESSIONAL DEVELOPMENT JOURNAL for the CONSULTING DISCIPLINES 20 SEPTEMBER | OCTOBER 2019 t h e v a l u e e x a m i n e r VALUATION /////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////// /////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////// A Candid Observation of the Cannabis Industry By William K. Fowler, CVA, ABAR, MAFF In the past few years, several states have legalized cannabis sales, and by doing so, created a huge new industry. The cannabis industry has created opportu- nities for business valuators to expand their expertise and services. Recently, I had the opportunity to review some of these cannabis valuations and decided to share some of the insights I have gained with other valuators who may be interested in this new field of valuation. One of the most critical insights I observed is that most of the valuations reviewed are written as a “calculation of value” and not a conclusion of value or detailed report. Nevertheless, all business appraisers must still adhere to USPAP’s Appraisal Standards. My observations concerning “calculation of value” are presented in the areas of: •Engagement letter •Discount rate • Weighting factors of approaches •The IRC 280E analysis with emphasis on the cost of goods sold calculation Additionally, critical to cannabis valuation is IRC 280E. Valuators must consider this federal tax issue whenever they attempt to value a cannabis business, especially if it is a plant- touching business. ENGAGEMENT LETTER Until there is a federal level of acceptance of the cannabis industry, another sentence should be added to the engagement letter to protect the integrity of the preparer. This step is especially critical for CPAs since they are held to a higher public standard and must protect their licenses. It is important to note that as far as the federal government is concerned, cannabis is still an illegal business. Therefore, it is prudent to include a provision that requires the client to affirm it is operating legally under applicable state laws. This provision may assist the CPA if the Department of Justice’s Office of Professional Responsibility pursues a CPA serving the cannabis industry. DISCOUNT RATE In one calculation of value, the valuator limited the discount rate to one sentence: “We estimated X’s Discount Rate/Cost of Equity to be approximately thirty percent.” There was no discussion at all of the rate build-ups; only this sentence to underscore an important factor in the derivation of the Discount Rate Method. It would be a thoughtful addition for discussion to know what the specific rates are, such as Risk-Free rate, ERP rate, and others that went into the concluded rate of thirty percent. Even though this is a calculation of value, there needs to be some resemblance to an actual valuation opinion, not just a one-liner. WEIGHTING FACTORS The two most common approaches used for cannabis valuation are the Market Approach and the Income Approach. The valuators generally proceeded through much detail throughout the analysis as to the weaknesses of the current market data metrics, yet in their analysis, they assigned more weight to the Market Approach. The reason for this conclusion was as explained in one such report: “Given that cannabis is a relatively new industry for which very little data is available and the fact that most companies are closely held and therefore not required to publish transaction details, we relied on market multiples realized in recent transactions through investment banks and private equity firms that we have relationships with to gain insight into dispensary exits and the valuation metrics that accompanied these deals.” The question that comes to mind is, did the preparer try to reconcile or check the two comparables as actually being reliable data? The question is significant since only two comparables were used as recent sales, and we now know that the metrics on recent sales are inherently high, as many of the valuators have stated throughout their valuations. A PROFESSIONAL DEVELOPMENT JOURNAL for the CONSULTING DISCIPLINES t h e v a l u e e x a m i n e r SEPTEMBER | OCTOBER 2019 21 Additionally, the multiples that were used in the Calculation of Value report were multiples of gross revenues. This seemed odd since 280E produces a much higher effective tax rate for illegal businesses, higher than seventy percent, and the resulting net income is far less than in actual non-cannabis businesses. Why in the world even attempt to use a multiple of gross revenues, especially since we are looking at cannabis plant-touching businesses and the application of 280E? IRC 280E Section 280E penalizes “traffickers of controlled substances,” such as cannabis, by denying deductions from gross income for business expenses. However, drug dealers do get a deduction for the cost of goods sold because it would be unconstitutional for Congress to deny this deduction under the 16th Amendment, which does not permit Congress to impose a tax on gross receipts. As one might imagine, the denial of ordinary business deductions greatly impacts those doing business within the plant-touching cannabis industry. Because the IRS does not allow normal business deductions for Schedule I drugs, this area of analysis for the valuator is essential for cannabis valuation. Similarly, due to severe taxation at the federal level on the production of an illegal Schedule I drug, it is imperative that much attention is focused on the extent of the cost of goods sold analysis. Schedule I drugs are taxed on gross income, not on net income as legal businesses are taxed, which makes a huge difference as to the effective tax rate cannabis businesses are faced with, usually higher than seventy percent, and in many of the valuations, it was over seventy percent. COST OF GOODS SOLD ANALYSIS The preparers in one analysis or calculation of value used an unsubstantiated forty percent of sales as the COGS for each year in the forecast period utilized for the discounted cash flow method analysis. The valuator’s report made this statement regarding COGS, “We believe it could be argued that approximately thirty percent of the ‘operating expenses’ could be reclassified as COGS in this case.” Seemingly, contrary to this statement, the preparers’ discounted cash flow analysis utilized a fixed forty percent of sales as the estimates going forward for COGS. The owners’ 2017 financials were the actual basis of the forty percent of sales calculation for COGS and used in all subsequent forecast years, as stated by the preparer. Doesn’t this fixed percentage call for more questioning of the owners? Especially, if an actual formal appraisal or detailed report is performed on this business, at a later date, wouldn’t the owners be shocked to know that possibly their forty percent of sales deriving the COGS would be called into question by the IRS? Finally, when performing a calculation of value, or any other business valuation, the preparers should be mindful of double-checking the accuracy of the numbers flowing into the discounted cash flow analysis. They must remember that the analysis must have a split rate for the state tax rate applied to taxable income and the federal tax rate applied to gross income. If an Excel spreadsheet is incorporated, then the formulas and this federal and state tax rate split can easily be accomplished, but without it, there can be a huge error in the calculation of net income and, of course, the derivation of value. Unfortunately, because of the 280E issue, when valuing cannabis-touching businesses, you can come across effective federal tax rates of seventy percent or even higher. With this in mind, the valuator must use multiples on an after-tax basis and only for businesses that are comparable to plant-touching businesses; otherwise, the valuation exercise can be for nil. CONCLUSION All valuation reporting, regardless of whether it is a calculation of value, a detailed report, or an appraisal report, is subject to USPAP standards; therefore, business valuations should still consider prudence and keep in mind, that regardless of whom is actually privy to a value calculation, or a value opinion, the old saying comes to mind, “an ounce of prevention is worth a pound of cure.” William K. Fowler, Emeritus, CVA, ABAR, MAFF, is a Senior Advisor at Nevium Intellectual Property Consultants. Mr. Fowler has over forty years of public and governmental accounting experience specializing in IRS litigation and support as an expert witness in business valuation and forensic issues. Recently, he has been called upon to evaluate valuation issues regarding the cannabis industry and intellectual properties, especially as it relates to IRS Section 280E and its tax implications. He is best known for the federal case of Kaufman vs. Commissioner in U.S. Tax Court regarding business valuation as it pertains to federal tax issues. E-Mail: VEA PROFESSIONAL DEVELOPMENT JOURNAL for the CONSULTING DISCIPLINES 22 SEPTEMBER | OCTOBER 2019 t h e v a l u e e x a m i n e r /////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////// VALUATION In the July/August Issue of The Value Examiner, two articles generated interest from readers. The authors of those articles have chosen to respond to their critics. In this issue, Roger Grabowski, FASA, Managing Director, Duff & Phelps LLC responds to the concerns raised by Joshua Feldman, CPA, CFE, CVA, AIAF Back to the Future (Parts I website. REBUTTAL: HOW NOT TO USE DUFF AND PHELPS DATA, MAY/JUNE 2019 There seems to be some confusion on the part of Joshua Feldman as to the correct method of summarizing historical return data used to discount expected net cash flows. This is not a simple topic, and his confusion is understandable. In building discount rates, we often use historic equity risk premium data as a building block. For example, Duff & Phelps publishes several equity risk premium estimates based on historical data: the historical long-term equity risk premium (ERP) data (since 1926), the “supply-side” long-term ERP, the long-term ERP data (since 1926) adjusted for World War II Interest Rate bias, and the “supply-side” long-term ERP adjusted for World War II Interest Rate bias.1 The most commonly used size-premia are also derived from historical return data: the CRSP Decile Size Premia and the Risk Premium Report Size Premia.2 Which is the correct estimate of expected returns from an investment in the stock market: the geometric average or its arithmetic average equivalent? They are both correct—it depends on the purpose for which one is using the estimate.3 1 These historical based estimates were published in the annual Duff & Phelps Valuation Handbook-U.S. Guide to Cost of Capital and are now published in the on-line Duff & Phelps Cost of Capital Navigator. 2 Ibid. 3 This section is an excerpt from Shannon P. Pratt and Roger J. Grabowski, Cost of Capital: Applications and Examples 5th ed (John Wiley & Sons, 2014), Appendix 8A, “Deriving ERP Estimates.” The geometric average (or compound rate of return) and the arithmetic average equivalent are both statistics that summarize a series of returns. For example, an analyst can summarize realized returns on the stock market (or realized risk premiums) by calculating both the geometric average of the realized returns (realized risk premiums) and the arithmetic average of the realized returns (realized risk premiums). These are statistics that summarize the same set of realized returns (realized risk premiums). There is only a single statistic when one summarizes realized returns (realized risk premiums) by their geometric average. But two statistics summarize realized returns (realized risk premiums) by their arithmetic average: the arithmetic average and the standard deviation around the arithmetic average. The arithmetic average is always greater than the geometric average because it captures the volatility in the realized returns (realized risk premiums) as measured by the standard deviation. Even if the analyst is estimating the returns on the stock market using a forward-looking dividend-discount model (often termed an implied ERP), the rate of return that equates the expected stream of dividends (and buy-backs) with the current S&P 500 is an implied rate of return, which is equivalent to a geometric average. The implied rate of return (or implied ERP) does not capture any of the expected volatility that will undoubtedly occur in the future. In cases where the analyst is estimating the expected accumulated wealth at a point in the future, the preferred estimate of the rate of return on an investment in the stock market is the geometric mean (or the implied return). This is the preferred statistic whether the geometric mean equivalent estimate of the rate of return is derived from a sample of years of realized returns (an ex-post estimate using the geometric mean of the returns from the sample years) or an implied rate of return estimate (an ex-ante estimate equivalent to a geometric mean). This guidance is also correct when using an estimate of the ERP. In both cases, the geometric mean will accumulate to the median of the expected wealth. ...the geometric mean measures changes in wealth Letters to the Editor ///////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////A PROFESSIONAL DEVELOPMENT JOURNAL for the CONSULTING DISCIPLINES over more than one period on a buy and hold (with dividends reinvested) strategy…The arithmetic mean would provide a better measure of typical performance over a single historical period.4 It is common for analysts to express their opinions as to the expected returns on common stocks and the ERP in terms of the expected compound rate of return (a geometric average equivalent).5 Using the arithmetic average of realized risk premiums as an estimate of the ERP in compounding (i.e., estimating the median of future cumulative wealth) will likely result in an estimate of future wealth that is biased high. But if the analyst is estimating the discount rate that should be used in discounting expected cash flows in future years, the preferred statistic (given certain attributes of the underlying probability function describing future returns) is the arithmetic average of realized returns (realized risk premiums) or the arithmetic average equivalent of implied returns (implied ERP). ...the arithmetic mean equates the expected future value of investment with its present value. This property makes the arithmetic mean the correct return to use as the discount rate or cost of capital.6 Even if we are using ex-post realized risk premiums as our ERP estimate, our goal is to estimate the ex- ante risk premium. A multiperiod project’s cost of equity is the expected return on an asset of the same risk over a one-period horizon, not the expected geometric mean rate of return on an asset measured over many periods...The expected one-period return is the same as the expected arithmetic mean of a series of a time-series sample of returns. This is larger than the expected geometric average unless the returns are certain and constant. Thus, we are using the sample of historic returns to estimate the ex-ante expected annual 4 Willard T. Carleton and Josef Lakonishok, “Risk and Returns on Equity: The Use and Misuse of Historical Estimates,” Financial Analysts Journal 41(1) (January–February 1985): 39. 5 Peng Chen, “Will Bonds Outperform Stocks over the Long-Run? Not Likely,” in Rethinking the Equity Risk Premium, ed. P. Brett Hammond, Jr., Martin L. Leibowitz, and Lawrence B. Siegel (The Research Foundation of CFA Institute, 2011): 117–129. Chen estimated the ERP as of early 2011 relying on the geometric average of the supply side model. 6 Roger Ibbotson and Rex Sinquefeld, Stocks, Bonds, Bills and Inflation: Historical Returns (1926–1987) (Chicago: Irwin Professional Publishing, 1989): 127. returns, not the ex-ante expected geometric mean rate of return.7 The use of the arithmetic average relies on the assumptions that (a) market returns are serially independent (not correlated) and (b) the distribution of market returns is stable (not time-varying). Under these assumptions, an arithmetic average gives an unbiased estimate of expected future returns, assuming expected conditions in the future are similar to conditions during the observation period. Moreover, as the number of observations increases, the resulting arithmetic average becomes a more accurate estimate. So while using the arithmetic average of realized risk premiums as an estimate of the ERP in compounding (i.e., estimating future cumulative wealth) will likely result in an estimate of future wealth that is biased high, using the arithmetic average of realized risk premiums as an estimate of the ERP in discounting expected cash flows to their present value equivalent does not introduce serious bias.8 Thus, analysts can be assured that the size premia as published by Duff & Phelps, which are derived from the arithmetic average of historical returns, can correctly be used as a building block in developing discount rates for discounting expected net cash flows (either using a single period capitalization of net cash flows or a multi-period discounted cash flow model). Cordially, Roger Grabowski, FASA, Managing Director, Duff & Phelps LLC Mr. Grabowski is co-author with Shannon Pratt of Cost of Capital: Applications and Examples, 5th ed. (John Wiley & Sons, 2014), The Lawyer’s Guide to Cost of Capital (ABA, 2014), and Cost of Capital in Litigation: Applications and Examples (John Wiley & Sons, 2010). He is a co-author of the annual resources for cost of capital data: on-line Cost of Capital Navigator, Valuation Handbook- Industry Cost of Capital, International Valuation Handbook - Guide to Cost of Capital and International Valuation Handbook - Industry Cost of Capital (Duff & Phelps). E-mail: 7 Seth Armitage, The Cost of Capital—Intermediate Theory (Cambridge University Press: 2005): 89. 8 See Pratt and Grabowski, “Is Bias Introduced by Using the Arithmetic Average as an ERP Estimate?" pp. 156–159. March/April 2017 23the value examiner VEA PROFESSIONAL DEVELOPMENT JOURNAL for the CONSULTING DISCIPLINES 24 SEPTEMBER | OCTOBER 2019 t h e v a l u e e x a m i n e r LEGAL INSIGHTS These days, many estates’ holdings include valuable paintings. As each picture is unique, valuation questions become prominent. Estate of Kollsman v. Commissioner, T.C. Memo 2017-40 (2017), is an instructive case about how not to value a painting properly for estate tax purposes. As such, it indirectly informs of how properly to value a painting. The tax court decided that the valuation expert for the estate had understated the true value of the paintings as part of the gross estate under Internal Revenue Code (IRC) Section 2031. Supporting this finding, the judge relied on the following issues: 1. The significant conflict of interest 2. Hyperbole involving the cleanliness of the paintings and the risks of cleaning them 3. Misstatement of arm’s-length valuation 4. Lack of comparable paintings in the valuation analysis of the valuation expert RELEVANT AUTHORITIES IRC Section 2001(a) authorizes the federal estate tax. The taxable estate base includes the gross estate less deductions under IRC Section 2051. The gross estate includes all property owned as of the date of death at fair market value under IRC Section 2031(a) and Treas. Reg. Section 20.2031- 1(b). These authorities help set the fair market value as what a willing buyer and seller—neither compelled to buy or sell and to have reasonable knowledge of the facts—would agree on as a transfer price.1 FACTS The estate included two 1600s-era, “Old Master” oil paintings on wood panels, “Village Kermesse: Dance Around the 1 U.S. v. Cartwright, 411 US 546 (1973). Maypole” (“Maypole”) by Pieter Brueghel the Younger (21.5 by 29.875 inches) and “Orpheus Charming the Animals” (“Orpheus”) by Jan Brueghel the Elder or the Younger (nineteen by twenty-seven inches). The estate’s valuation expert was the vice president of Sotheby’s and co-chairman of Sotheby’s “Old Master” Paintings Worldwide. He viewed the paintings many times over the years during visits to the decedent. Near the decedent’s death, this expert wrote to the future executor and beneficiary of the decedent’s estate, discussing how Sotheby’s would handle the auctioning of the two paintings. Preliminary estimates were $600,000 to $800,000 for “Maypole” and $100,000 to $150,000 for “Orpheus.” In a letter sent to the future executor and beneficiary of the decedent’s estate, the fair market values were $500,000 and $100,000, respectively. This letter became documentation for the estate’s tax return. In a second letter, the Sotheby’s auction terms, (granting the auction house exclusive rights to auction the painting for five years) were enunciated with a rate of twenty percent on the first $200,000 and twelve percent above that amount. The terms changed on the actual auction of the paintings to twenty-five percent on the first $50,000, twenty percent on greater than $50,000 but less than one million dollars, and twelve percent on an amount greater than one million dollars. A restoration company was consulted that believed the paintings should be cleaned. The restoration expert had to have insurance coverage of one million dollars for “Maypole” and $200,000 for “Orpheus.” A previous property-casualty insurance policy had coverage of $600,000 and $80,000, respectively. The restoration expert determined that “Maypole” had “heavy” “surface dirt” and a “barely visible” signature judged through a visual review and a detergent test. “Orpheus” had “heavy” “surface dirt,” and “none visible” for the signature By Kevin A. Diehl, JD, CPA Valuing a Painting For Estate Tax Purposes: Estate of Kollsman v. Commissioner /////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////// ///////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////A PROFESSIONAL DEVELOPMENT JOURNAL for the CONSULTING DISCIPLINES t h e v a l u e e x a m i n e r SEPTEMBER | OCTOBER 2019 25 discussion. There was a “convex warp” and the painting was “substantially bowed at the top and bottom.” “Maypole” sold 3.5 years after the valuation date for $2.1 million; $2.4345 million including the buyer’s premium. At that auction date, the ten highest sale totals for “Old Master” paintings in New York City ranged between $109 million and thirty-nine million dollars. While the estate relied on the $500,000 and $100,000 valuations, Internal Revenue Service (IRS) believed the true valuations to be $1,750,000 and $300,000. The IRS amended its answer as $2,100,000 and $500,000. DISCUSSION A valuation expert has a duty to the court higher than the duty to the client.2 Testimony must be neutral and without bias.3 In valuation cases, becoming an advocate renders the expert anything but useful. The insurance valuations were not probative regarding fair market valuation. Insured values are generally higher than fair market value. As to the $500,000 and $100,000 valuations compared to the ultimate $2.4345 million sale price of the “Maypole,” the estate’s expert argued the quality of the paintings had improved upon cleaning. The expert further explained the market demand had increased substantially because of an influx of Russian buyers of “Old Master” paintings. For “Orpheus,” the estate’s expert believed “the Younger” had painted it. This fact would mean it would be worth less than if “the Elder” had completed it. The court found the conflict of interest for the estate’s expert to be significant. As such, it questioned the expert’s objectivity because there was an incentive to give a lower valuation to the beneficiary to lower estate tax obligations. This action, in turn, could potentially win the exclusive auction rights. If cleaning the picture was so dangerous and would affect the values so much, the expert certainly would have raised these issues with the ultimate beneficiary. Also, the expert should have sought a cleaner’s opinion as to whether they could be cleaned and the final effect on valuation. Comparable paintings values at auction must be used to help establish value. Here, the estate’s expert did not refer to any similar painting’s valuation to determine values. The subsequent sale price could be used as fair market value evidence on 2 Estate of Halas v. Commissioner, 94 T.C. 570 (1990). 3 Ibid. the valuation date if intervening market conditions are considered. The IRS’s expert was credited for valuing based on the popularity of the scene, artist’s direct participation in the work, condition, dimensions, provenance, literature citation, and comparable paintings’ auction prices. The IRS’s expert instead attributed “Orpheus” to “the Elder,” increasing its value significantly. The court accepted the valuation of the IRS’s expert but with a five-percent discount to account for the risk of cleaning. This discount meant $2.1 million times ninety-five percent ($1,995,000) for “Maypole.” In addition to the five percent discount for cleaning risk, the court also imposed a ten percent discount for bowing in the “Orpheus.” With an attribution dispute, the court added another discount to the “Orpheus” of ten percent. As such, the court found “Orpheus” to have a $500,000 times seventy- five percent valuation ($375,000) on the valuation date. PLANNING TIPS 1. Estate valuation experts should not have an interest in what they are valuing. 2. Paintings’ valuations must be established primarily through comparable paintings’ valuations. 3. Paintings’ valuation should also consider the popularity of the scene, the artist’s direct participation in the work, condition, dimensions, provenance, and literature citation. THE FUTURE As future estates are likely to include even more challenging to value things like intellectual property, valuation for estate tax purposes should continue to be an area worthy of exploration. For now, estate planners should take heed of what advice Estate of Kollsman v. Commissioner has to offer. Kevin A. Diehl, JD, CPA, has advised Fortune 500 companies on domestic and foreign tax issues. He currently teaches online and in- person tax courses in the Department of Accounting and Finance at Western Illinois University—QC, in which he covers nearly every area of tax and valuation principles related to each. 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What would that intelligence be worth to you? 2019 HIGH GROWTH STUDY EXECUTIVE SUMMARYA PROFESSIONAL DEVELOPMENT JOURNAL for the CONSULTING DISCIPLINES t h e v a l u e e x a m i n e r SEPTEMBER | OCTOBER 2019 27 Academic Research Briefs: An Overview of the Literature on the Cannabis Industry By Peter L. Lohrey, PhD, CVA, CDBV /////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////// /////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////// The purpose of this column is to provide the readers of The Value Examiner, summaries of contemporary research in business valuation and forensic accounting. The manuscripts covered are selected from numerous academic research outlets that include relevant topical coverage of valuation and related forensic accounting issues. The objective is to illustrate the core of this novel research while increasing awareness among the community of the subject matter. As this column evolves, I encourage the readership to forward relevant manuscripts or working papers for consideration. Please send links and/or files or the subject line. This edition’s column deviates from prior columns, in that I have been asked to provide insight into the current state of business valuation regarding the cannabis industry. Since the industry is in an early stage of development, there is very little, if any, academic research available that uses archival data. I will, therefore, provide a summary of the current practice-oriented literature about the valuation of companies that operate in the cannabis industry. CANADA LEADS THE WAY On October 17, 2018, the Canadian Federal Government adopted the Cannabis Act, Bill C-45, thereby legalizing the recreational use of cannabis in Canada.1 This places Canada in a position where it can lead the way for cannabis companies around the world. Hence, Canadian cannabis companies are pursuing growth by acquiring competing companies. This, in turn, has placed an increase in emphasis on the importance of business valuation in this newly born industry. This situation reminds me of the “.com”—or internet bubble—where rapid growth was achieved through acquisitions back in the late 1990s to early 2000s. 1. Uruguay was the first country in the world to fully legalize the use of marijuana on December 23, 2013. HOW TO VALUE A POT STOCK Authors: Tara Lachapelle and Sarah Halzack Source: Bloomberg Opinion, April 18, 2019. bloomberg.com/opinion/articles/2019-04-18/altria-shows- there-s-a-better-way-to-value-cannabis-stocks Lachapelle and Halzack (L&H) begin by asking, “How do you even value a pot business?” They point to the purchase of a forty-five percent interest in the Canadian cannabis producer Cronos Group Inc. by Altria Group, Inc., the U.S. maker of Marlboro cigarettes, for $1.8 billion in December 2018. They are in a conundrum regarding how Altria valued Cronos— for Cronos’ sales were only four million dollars in the period before the deal—and they had no profits. This same fact pattern held when Constellation Brands Inc., a beer and liquor conglomerate, spent $3.8 billion to increase its ownership interest in Canopy Growth Corp. earlier in 2018. L&H point to the tremendous projected growth for the worldwide cannabis market, which has certain investors pouring money into brand new companies that have minuscule revenue and no income. They point to other industries where a company’s assets will potentially have great value in the future, but cannot be easily measured just yet. Next, L&H propose looking at other industries where their businesses are not perfect comparables, but where the method of valuing these businesses may be informative. The first industry they examine is natural resources (which uses non- financial metrics such as production capacity and tangible assets like verified oil reserves), thereby translating into how much fuel a producer can extract from their land. They assert that this could be considered analogous to how investors gauge cannabis companies, with the focus being kilograms of output per acre of greenhouse owned. L&H then eliminate this approach due to its focus on supply-chain practices that may become commoditized, and thereby overlook how the early powerhouses in the market differentiate themselves. ACADEMIC REVIEWA PROFESSIONAL DEVELOPMENT JOURNAL for the CONSULTING DISCIPLINES 28 SEPTEMBER | OCTOBER 2019 t h e v a l u e e x a m i n e r L&H proceed to explain that the biotechnology industry may provide a more suitable comparison when determining how to value a cannabis company. They believe that the similarity lies in the fact that investors are making risky bets on future prospective bestsellers. Also, L&H compare more advanced cannabis companies’ efforts to develop specialized brands to pharmaceutical companies’ efforts to develop patented drugs. These early leaders in the cannabis industry want to be the first to develop strong customer relationships/loyalty for their brands. Finally, L&H believe that as the recreational cannabis market grows beyond the medical one, brand differentiation will be the key to early success. They believe that value in the cannabis market of the future will be driven by the ownership of unique brands by management teams with proven success differentiating their brands in other industries such as soft drinks, coffee, and specialty clothing. They believe that the companies that become industry leaders in the legal cannabis era will be the ones that have the insight on how to create demand for their products through a great retail experience or captivating marketing. MARIJUANA SECTOR’S ACCOUNTING QUIRKS GENERATING “AUDITED HALLUCINATIONS” Authors: Sean Kilpatrick and Kristine Owaram, The Canadian Press and Bloomberg News Source: The Globe and Mail, January 24, theglobeandmail.com/globe-investor/investment-ideas/ marijuana-sectors-accounting-quicks-generating-audited- hallucinations/article37716105/ Kilpatrick and Owaram (K&O) write about the accounting fluke that makes the financial statements of marijuana growers look exceptionally good; which, in turn, provides an artificial boost to their valuations. At the time this article was written, there were eighty-four listed marijuana stocks in Canada with a value of $36.9 billion. And that was before the legalization of recreational cannabis in July 2018. K&O draw attention to the fact that Canadian cannabis growers comply with International Financial Reporting Standards (IFRS) (and these rules employ a fair-value model for agriculture), which forces these companies to value plants while they are still growing in the ground. Further, they point to Al Rosen, founder of Toronto-based Accountability Research Corp. Rosen, a veteran forensic accountant and long-time critic of how the IFRS fair-value rule is applied to the cannabis industry, stated, “It’s audited hallucinations. Marijuana financial statements have absolutely nothing to do with reality.” The problem, according to K&O, lies in the fact that under IFRS, cannabis growers report the unrealized, non-cash change in the fair value of their plants as they grow, and compare this to the theoretical selling price. This requires that several estimates be made by management (including the price the drug sells for), while the Canadian government had provided no guidance on selling price when this article was published. Hence, as the unrealized value of the plants is included in gross profit, companies that add plants faster than the sale of their inventory—which almost every producer is doing—can report gross margins exceeding one-hundred percent of sales. Tim Saunders, the chief financial officer of Canopy Growth Corp., the world’s largest cannabis company, stated, “We all recognize that the statements are not very helpful to anyone.” Canopy had a market value of more than seven billion dollars and an IFRS gross margin of one hundred sixty-four percent in the third quarter of 2018. Rosen points out that Canopy’s IFRS gross margin was one hundred eighty-six percent in the third quarter of 2016 but fell to sixty percent after removing the IFRS fair-value metrics. K&O state that excessive plant valuations can lead to big write-offs in an industry that is already predisposed to ferocious price fluctuations. In light of this, many of the large cannabis companies took steps to explain their results by adding specifics in the management discussion and analysis (MD&A) section of their financial statement disclosures so that investors can obtain a more transparent picture of their profitability. However, problems remain due to the lack of industry standardization outside of IFRS rules. This, in turn, allows each company to make different assumptions from their competitors when presenting their financial statement results to investors. CANNABIS: VALUATION APPROACHES IN AN EVOLVING MARKET Authors: Neal Mizrahi, Natalie Quinn, and Sheri Herblum, FTI Consulting Source: FTI Consulting, June fticonsulting.com/~/media/Files/us-files/insights/white- papers/cannabis-valuation-approaches-evolving-market.pdf Mizrahi, Quinn, and Herblum (MQ&H) begin this paper A PROFESSIONAL DEVELOPMENT JOURNAL for the CONSULTING DISCIPLINES t h e v a l u e e x a m i n e r SEPTEMBER | OCTOBER 2019 29 by tracking the history of the legalization of cannabis for recreational use by the Canadian Government on October 17, 2018. They describe the current state of the industry in Canada and point to the “second wave” of cannabis legalization expected to take place on October 17, 2019; which relates to edibles, concentrates, and topicals.2 MQ&H point out that common valuation approaches need to be 2. modified to arrive at reasonable valuations due to the limited historical financial information upon which to base projected future earnings (Income-Based Approach) and determine comparable company values (Market-Based Approach). MQ&H provided the following diagram, which outlines the most frequently used valuation approaches and evaluates their application to the cannabis industry. MQ&H next provide the following table where Canada’s twenty largest cannabis companies’ valuation metrics are presented under the Market-Based Approach using the Guideline Public Company Method.Next >