By Lane Bruns, ICANIVEST

Executive Summary and Results

This article identifies the variables in the DCF (discounted cash flow) valuation model that will immediately change if and when cannabis is rescheduled to a Schedule 3 or below drug. It also quantifies the impact of 280e on DCF valuations (1,2) thru a hypothetical cannabis company. There has been plenty of discussions on increasing cannabis company valuations if and when IRS 280e (3) is removed, but other than a few companies highlighting the reduction in federal income taxes owed, we haven’t seen a holistic approach to studying the impact of removing 280e. It is important to note we only identify and quantify variables that are “immediately” impacted in the DCF valuation formula. We do not consider “secondary” benefits of valuation that are likely to occur after 280e because of the improved financial landscape like M&A, increasing Capex, refinancing debt, issuing more stock, etc. (4) , as that is beyond the scope of this article.

The reduction of tax rates due to removal of 280e directly and immediately impacts 2 of the 3 variables in a DCF model: Free Cash Flow to the Firm (FCFF) and Weighted Average Cost of Capital (WACC), it does not immediately impact the Growth Rate of the firm(g). To quantify how the 2 variables increase DCF valuations post 280e, we use a very simplistic, hypothetical company which produced a 7.59x higher valuation. (5)

Figure 1: Quantitative impact of 280e on the DCF valuation of hypothetical cannabis company

	Pre 280e	Post 280e	Factor Increase
DCF Valuation	$1.76	$13.36	7.59x

Background

The Executive and Administrative actions by the President, Health and Human Services (HHS), and Drug Enforcement Agency (DEA) regarding the rescheduling of cannabis are substantial developments that could significantly improve the financial fundamentals and valuations of cannabis companies. There have been discussions on what rescheduling would mean for the industry, but this article focuses only on one aspect of rescheduling, which is the impact on cannabis company valuations if the IRS 280e federal tax is removed. But first, some background.

Approximately 1 year after Biden requested the Health and Human Services (HHS) to look at reclassifying cannabis from a schedule 1 drug to a lower classification, the HHS gave its recommendation to reclassify cannabis as a Schedule 3 drug to the DEA on Aug 31, 2023. The next step (duration unknown) is for the DEA to make its recommendation (which is also unknown) and proceed with the Formal Rule making process (public comments/lawsuits/etc) to codify the change into law. IF the DEA
agrees with the HHS and successfully reclassifies cannabis as a schedule 3 or lower drug, then the punitive federal IRS 280e rule no longer applies to cannabis companies and they  will no longer be required to pay federal taxes on gross margins but instead will pay on net income (like most other businesses).

So, let’s start by identifying what 280e removal doesn’t do:

1. It does not increase company’s revenues or gross margins
2. It does not make every company have positive net income or positive eps
3. It does not mean uplisting to higher exchanges
4. It does not make interstate commerce legal
5. It does not mean existing debt disappears
6. It does not mean national banks will allow cannabis companies to use their bank services
7. It does not mean Cannabis is legal recreationally
8. It does not mean the federal agencies will start to enforce FDA/DEA oversight

DCF company valuations

Figure 2: DCF for Firm

Value of Firm = FCFF / (WACC – g)        where as

FCFF = Free Cash Flow to Firm
WACC = Weight Average Cost of Capital
g = Growth rate of the firm

Credit: Dr. Aswath Damodaran, (1996), Investment Valuation, John Wiley & Sons, Page 240

Analysts value companies by price comparison multiples (P/E, EV/Sales, EV/EBITDA, etc.) 6 or DCF models. Figure 2 shows the DCF equation that estimates the value of an investment using its expected future cash flows of the firm (FFCF) discounted back to present value with weight average cost of capital (WACC) minus the Company’s growth rate (g). Said another way, DCF analysis attempts to determine the intrinsic value of an investment based on projections of how much money that investment will generate in the future, discounted back into today’s dollars. A benefit of the DCF model is that it can incorporate special situations like applicability of 280e by including details of the financial income, cash flows, and balance sheet into the model. Furthermore Figure 2 shows us how value of the DCF is impacted by 280e. The numerator, FCFF, and the denominator’s, WACC are impacted by 280e. The growth rate of the firm (g) is not immediately impacted by 280e. 7 Figure 3 is a more thorough illustration of the DCF model by Dr. Aswath Damodaran, and we can see the WACC is made up proportionately of the cost of equity and cost of debt which are both impacted by 280e.

Figure 3: Detailed description of DCF Model

 

 

Increases Numerator: Decrease in Federal Tax Rate leads to Increase in FCFFs

Much of the current discussion around the removal of 280e comes from cannabis CEOs highlighting the reduction in future federal taxes owed to the IRS, which is certainly important and significant in itself. They are focusing on the benefits of 280e as a result of increased FCFF which can be calculated in DCF Model terms as Figure 4:

Figure 4: DCF Equation for FCFF

EBIT (1-tax rate)
+ Deprecaition
– Cap Expenditure
– Δ Working Capital
= Free Cash Flow to Firm

In our hypothetical model we use an effective tax rate (federal and state taxes) of 70% with 280e and 26% without 280e. So the first line immediately changes from EBIT * (1-.70) with 280e to EBIT *(1-.26) without 280. Figure 4 shows the FCFF in our very simple model single stage model where we hold everything constant (no growth in rev, no growth in EBIT, etc.). The lower tax rate increases the FCFF or numerator each year from $120M with 280e to $296M without 280e. (8)

Figure 4a: FCFF with and without 280e

	With 280e	Without 280e
Revenue growth rate	0.00%	0.00%
Revenues	$ 2,000,000	$ 2,000,000
EBIT (Operating margin)	20.00%	20.00%
EBIT (Operating income)	$ 400,000	$400,000
Tax rate	70.00%	26.00%
EBIT (1-t)	$ 120,000	$ 296,000
Reinvestment	$ -0-	$ -0-
FCFF	$ 120,000	$ 296,000

FCFF can also be looked at from a financial statement perspective, where deducting operating expenses, deducting interest payments, decreasing federal taxes all Increase net Income at ceteris baris increase FCFF.

Decreases Denominator- Decrease after-tax Cost of Debt decreases WACC

A more subtle but important variable that also immediately positively impacts valuations is the decrease in the denominator due to a decrease in the cost of debt and therefore in WACC.

Figure 5: Factors of Cost of Capital 9 (5)

 

Without 280e

After-tax Cost of Debt = (risk free rate + default spread) * (1-tax rate)

With 280E

After-tax Cost of Debt = (risk free rate + default spread)

 

WACC is the denominator of the DCF formula shown in Figure 2. WACC is equal to weighted cost of equity + weighted cost of debt. Since 280e is a tax issue, it immediately impacts the cost of debt. Figure 5 shows the cost of debt without 280e decreases the denominator (making the valuation higher) by multiplying (1-tax rate) X (risk free rate + default spread). However, cannabis companies with 280e cannot deduct interest from cost of debt, so they have to use only (risk free + default spread). Continuing with our theoretical company, Figure 6 quantifies the advantage of multiplying (1-tax rate) by the cost of debt and shows how much it reduces the denominator. In our model risk free rate = 4% and the cost of debt is 11%.

Figure 6:

With 280E @ after tax cost of debt = (risk free + default spread)

Cost of Debt is 15% = (4% + 11%)

	Equity	Debt	Capital
Market Value	$ 500,000	$ 500,000	$ 1,000,000
Weight in Cost of Capital	50.00%	50.00%	100.00%
Cost Component	28.00%	15.00%	21.50%

 

Without 280E @ after tax cost of debt = (risk free+ default spread) * (1- tax rate)
Cost of Debt is 11.69% = (15% *.78) where tax benefit of (1-.26 tax rate) decreases the denominator

	Equity	Debt	Capital
Market Value	$ 500,000	$ 500,000	$ 1,000,000
Weight in Cost of Capital	50.00%	50.00%	100.00%
Cost Component	24.88%	11.09%%	17.98%

 

Decrease Denominator – Decrease in Equity Beta

From Figure 5 you can also see that the Cost of Equity is also in the denominator as a part of WACC. Determining the Cost of Equity is difficult because the variables that make up this component include an equity beta which is tricky. Putting the value aside, we focus on the equation for equity beta that is determined by the type of business, the financial leverage, and the operating leverage. And because financial leverage is an aspect of equity beta, where tax rates are important. The formula in the DCF model for Beta of Equity of a leverage firm (L) is Beta L = Beta U * (1+(1-tax rate) *(D/E). In Figure 7, you can see how the leverage beta for equity goes from 4 with 280e to 3.48 without 280e and the cost of equity drops from 28.00% with 280e to 24.88% without 280e, once again decrease the denominator and increase the company’s valuation.

Figure 7:

With 280e @ cost of equity is a function of the equity beta of a leverage firm which is
Beta L = Beta U * (1+(D/E)

Unlevered beta =	2.00
Riskfree Rate =	4.00%
Equity Risk Premium =	6.00%
Levered Beta for equity =		4.00

 

	Equity	Debt	Capital
Market Value	$ 500,000	$ 500,000	$ 1,000,000
Weight in Cost of Capital	50.00%	50.00%	100.00%
Cost of Component	28.00%	15.00%	21.50%

 

Without 280e @ cost of equity is a function of the equity beta of a leverage firm with the advantage of
the tax rate since taxes are deductible
Beta L = Beta U * (1+(1-tax_rate) * (D/E)

Unlevered beta =	2.00
Riskfree Rate =	4.00%
Equity Risk Premium =	6.00%
Levered Beta for equity =		4.00

 

	Equity	Debt	Capital
Market Value	$ 500,000	$ 500,000	$1,000,000
Weight in Cost of Capital	50.00%	50.00%	100.00%
Cost of Component	28.00%	11.09%	17.98%

 

Conclusion: Putting it all together:

Figure 8: DCF values as a reflection of variable values

Low DCF values	High DCF values
Low growth	High growth
Low FCFF	High FCFF
High WACC	Low WACC

Figure 8 summarizes ALL the variables in the DCF formula and their proportional impact on valuations. Figure 9 takes it one step further and shows only the 2 variables that are impacted by 280e and their directional impact on valuation. Notice in figure 8 there is the growth variable (g) but since that is not (7) impacted by 280e it is not listed in figure 9. Figure 9 shows the direction the 2 variables (FCFF and WACC) would immediately move in the DCF model if 280e were removed. In fact, as we described above, WACC is positively impacted twice by variables in debt and equity. As you can see in the last column all of the impact from the variables changing create higher DCF values.

 

Figure 9: DCF Numerator and Denominator Impacted by 280e and result on DCF Valuations

DCF	Variable	Pre 280e	Post 280e	DCF Valuations after 280e removal
Numerator	FCFF	lower	higher	Higher
Denominator	WACC (debt)	higher	lower	Higher
	WACC (equity Beta)	lower	higher	Higher

 

Increasing numerator and decreasing denominator = HIGHER VALUATIONS

In this hypothetical company in Figure 10, we see an immediate increase in company valuation from $1.76 to $13.36. or 7.59 times! Of course, all of the variables used in the DCF model will affect the resulting multiple increase/decrease of the company’s valuation and we have made some assumptions in this model (i.e. not reducing the cost of capital over time, keeping revenues flat, etc.). In fact, we are not suggesting that all or even any cannabis company will see a 7x increase in value if 280E is removed, the market is far more complicated than our equations and models. Rather our goal is to highlight the variables in the model and illustrate how they can impact valuations if the 280e tax is removed.

 

Figure 10: Hypothetical Company’s DCF Model Valuation and Impact of 280e

Variable	Example Value with 280e	Example Value without 280e	Impact to Valuation without 280e
FCFs	$ 120,000	$ 296,000	Higher cash flow = Higher numerator
Cost of Debt	15%	11.09%	Lower Cost of Debt
Cost of Equity	28%	24.88%	Lower Cost of Capital
WACC	21.50%	17.98%	Lower WACC = Lower denominator
Estimated Value/Per Share	$1.76	$13.36	7.59 X HIGHER VALUATION

 

Next Steps

At ICANIVEST we applied the same framework to actual cannabis companies with actual numbers from their financial reports to calculate their DCF valuation and determine their expected immediate “factor increase” pre and post 280e. Of course, each company increase “factor” varies depending on the (8) company’s capital structure (debt/equity, preferred shares, options, cash on hand), operating results, etc. But even more importantly, at ICANIVEST we also modeled in the secondary impacts of a reduced tax rate based on each company’s profile. Specifically, we modeled in the changes to growth rates, reducing debt costs, different capital structures, changing beta, issuing more stock, etc. to try and tell the full story of how the removal of 280e will impact each individual cannabis company valuations.

_______________________________________________________________________________________

1 This is a companion paper to “The immediate impact of Cannabis Companies’ Price Comparison Multiples as a result of
removing the IRS 280E federal tax.”

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 The 280e IRS Code – “No deduction or credit shall be allowed for any amount paid or incurred during the taxable year in
carrying on any trade or business if such trade or business (or the activities which comprise such trade or business) consists of
trafficking in controlled substances (within the meaning of schedule I and II of the Controlled Substances Act) which is
prohibited by Federal law or the law of any State in which such trade or business is conducted.”

4 Some believe the “secondary benefits” will increase valuations even more than the “immediate” impacts.

5 Every company will have a different “factor increase multiple” based on fundamentals of that specific companies (i.e. cap
structure, operating results etc.).

6 This is the topic of the companion article called The immediate impact of Cannabis Companies’ Price Comparison Multiples as a result of removing the IRS 280E Federal tax.

7 When valuing actual cannabis companies, ICANIVEST does not use a simple DCF model but instead uses a multiple stage model with various growth stages and a terminal value. We discount those periods back with different WACC to get a more robust evaluation of cash flows.

8 A variable that could also impact FCFF that we didn’t include our model is net operating losses. Specifically, under 280e,
companies cannot bring net operating losses (NOLs) forward to offset future taxes, however without 280e they will be able to
bring NOLs forward which will reduce future fed and state taxes if the company had a net loss.

9 Dr. Aswath Damodaran

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 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.