You can also find plenty of investment gurus online touting the best cannabis companies or stocks to invest in or predicting what will be the next big thing in cannabis, but can you really trust them?
© Lightspring / Shutterstock.comThe most profitable and safest way to invest in cannabis is no secret: Put your money in the best companies. While that certainly sounds easy enough, how do you know which cannabis companies are best? How do you really know that a company will be successful and that you’ll earn a good return on your investment?
The answer is, you don’t. However, you can increase your odds by investing in profitable businesses, or businesses that have what it takes to be profitable. Following are 11 criteria for choosing a business to invest in.
A business doesn’t have to meet all ten criteria to be a good investment. For example, if a business has a great management team, the fact that the business isn’t profitable yet may be less important. However, you should consider all these criteria before investing in any cannabis business.
Experienced and successful management team
I cannot stress enough the importance of vetting the people who are running the business. These are the folks who will make or break the business (and your investment), so you want to be sure they’re knowledgeable and experienced in both cannabis and running a business, and that they don’t have a history of failed business ventures. Here’s what to look for:- Any past criminal activity that could be a warning sign that the business is not legitimate, such as past Securities and Exchange Commission (SEC) violations
- Cannabis knowledge and experience
- Business management knowledge and experience
- No long track record of failed business ventures
- A positive reputation — respected in the cannabis industry or in business circles
An individual rarely has all of the qualities needed to run a successful cannabis business. For example, someone with loads of cannabis knowledge and experience may not have business or people management expertise. However, the management team, as a group, should have all of the knowledge, skills, and experience required.
Steady revenue growth
Revenue growth is a good indicator of a business’ success, showing whether sales are increasing or decreasing. If revenue growth is steady or negative, the business is failing to remain competitive. Check the business’ revenue from month to month and from quarter to quarter. If the company has been in business for several years, look at its annual revenue from one year to the next. You can find a company’s revenue on its income statement.To compare revenue growth between two or more businesses, convert the dollar values to percentages. Start with this year’s revenue, subtract the revenue from the same period last year, divide the result by last year’s revenue, and then multiply by 100. Note that you don’t need to know the revenue for an entire year to make this calculation. For example, suppose it’s July, so the business only has revenue from the first six months of this year. This year, the company had $10 million in revenue. For the first half of last year, the company had $8 million in revenue. Its revenue growth as a percentage is:
($10 million – $8 million)/$8 million x 100 = 25%
Consistent profit growth
Profit is total revenue minus total expenses. A positive result means the business has earned more than it has spent. A well-run business shows growth not only in revenue but also in net profit. Negative or declining profit growth with rising revenue growth could be a sign that a business’ operational efficiency is dropping — that revenue isn’t keeping up with increases in expenses to operate the business.A negative profit margin (revenue minus expenses) is not necessarily bad. Successful businesses often operate at a loss when they’re investing toward future growth. If profit growth is negative or declining, dig deeper to find out what the business is investing in, how it’s getting the money to continue operating, and, if it is borrowing money, whether it has the means to make the loan payments.
Comparatively low price-to-earnings ratio
What is the price-to-earnings (P/E) ratio? It is a stock’s share price divided by its earnings per share, which is the company’s total profits divided by the number of shares. Suppose a stock’s share price is $10, its annual profit is $1 million, and the total number of shares is 500,000. Earnings per share is $1 million divided by 500,000, which equals $2 per share. The P/E ratio is $2 divided by $10, which is a ratio of 5 to 1.By itself, the P/E ratio doesn’t tell you much, but when you compare it to the P/E ratios of other companies in the same business, it’s a good indicator of whether a stock’s price reflects the company’s value. A comparatively low P/E ratio may indicate a good value for your investment.
Don’t consider the P/E ratio in a vacuum. A company that’s growing fast and investing heavily in that growth may have a high P/E ratio but be a better investment than a company that’s more profitable now but is losing market share.
Positive money flow indicator
One way to gauge a company’s value is to check the money flow index (MFI), which measures the momentum of a security by looking at movements of trading volume and price. If investment dollars are flowing toward one company and away from another, this trend could be a sign that the company drawing more investor interest is on its way up, while the other company is on its way down.The MFI falls into the realm of technical analysis, and it may not be the best indicator of a company’s health. A rising share price could be an indicator of a pump-and-dump scheme or simply that the company’s name was mentioned in a news article that shed a positive light on it. It’s more an indicator of investor sentiment than the health and vitality of the business.
Expanding free cash flow
When a company has a positive cash flow (is earning more than it’s spending), it has money to reinvest in the business, settle debts, pay expenses, build a buffer against future financial setbacks, and even share its profits with investors. Generally speaking, you want to invest in companies that demonstrate an increasingly positive cash flow.In a young industry like cannabis, in which businesses are just getting started, fewer businesses are likely to have a positive cash flow, let alone an expanding free cash flow. They’re more focused on getting started and growing. In addition, too much free cash flow could be a sign that the business isn’t spending enough money for growth or isn’t leveraging the money it has as optimally as possible.
Operations in other states or countries
Due to laws prohibiting the sale and transportation of marijuana across borders, cannabis businesses often struggle to survive in their own jurisdictions and face even greater challenges establishing operations in other states and countries. However, those that are successful in increasing their reach tend to be impacted less by challenges or setbacks in individual markets. In addition, they’re better positioned to expand into other markets as marijuana laws are relaxed.Growing market
Markets for certain products expand and contract. For example, the market for vape products in the cannabis industry is huge, because many consumers want a similar experience to smoking it, without the smoke. However, when people started getting sick from black market vaping products, the vape market took a huge hit. It has since recovered, but this example shows how industries can be affected by new products (vapes) and news.Before investing in a company, consider how well it caters to current consumer demand and how well it adjusts to changes in consumer demand. In many ways, the cannabis industry is like the smartphone industry — to be successful, a cannabis company must be able to stay ahead of the curve on consumer demand.
Increasing market share
The cannabis industry is highly competitive, and demand for product isn’t unlimited. To grow, businesses must increase their share of the pie; they can’t simply make more pie (increase demand). And, the ability to grow by expanding into different markets is often restricted by legal and regulatory issues. So, when investing in cannabis, look for companies with increasing market share.You may be able to find out a cannabis company’s market share by researching on cannabis business news sites. Or, you can search these same sites to find out the total revenue for the industry in the country or state in which the company operates and then divide the company’s revenue by the industry’s revenue for that same period.
Positive reputation in the industry
As you immerse yourself in the cannabis industry and read cannabis newsletters and other publications, you’ll begin to notice the names of companies and people appearing again and again. Pay close attention to which companies and people seem to be leading the industry. Which people are renowned authorities in the industry? Which companies and people seem to be the most highly respected? Then, research these companies and individuals to find out what they’re doing and what they’re saying about other businesses and individuals in the industry.As you begin to identify the movers and shakers in the industry, you’ll develop a better sense of where to invest your money. Who’s partnering with whom? Where are cannabis companies going to buy the products and services they need? You can often tell a lot about a company by looking at its business associates.
Manageable debt
Plenty of companies, including cannabis companies, struggle with solvency. Excessive debt is a key issue in today’s economy. When domestic energy became a hot industry a few years ago, many of those companies ultimately went bankrupt due to unsustainable debt. Imagine if you didn’t have enough income to cover your mortgage, utility bills, and credit card payments — the same thing can happen to businesses. Managing debt is a critical success factor especially for cannabis (or any) companies that are not yet profitable.You also want to look at the debt holder. Some companies, particularly those that seek aged debt, are toxic lenders. Avoid any company that has debt holders with convertible notes or aged debt — it’s a killer.