Why Marijuana May Be on the Verge of a Breakout

There has been a lot of news in the marijuana industry this year.

The medical marijuana industry exploded, and many new companies came to market in a frenzy, which reminded investors of the exciting technology bubble. And the Federal Government introduced legislation to make the use of marijuana legal across the country.

Once that last announcement hit the news, share prices did not seem to move as much as anticipated. Instead, the news was already priced in, and investors had already enjoyed the increase in share prices that would’ve come from this announcement.

Now more than halfway through the year, shares of Canopy Growth Corp. (TSX:WEED), which is the industry’s largest competitor by market capitalization, have traded sideways for several months. As is often the case, the company and the industry may be experiencing the calm before the storm.

As the time to legalization is less than one year away, investors will soon be able to count down to when the product becomes mainstream and top-line revenues increase substantially.

Canopy is currently trading sideways, as the excitement has finally subsided, creating a clear baseline for the industry. With shares trading at slightly less than $9, the price is bouncing between the 50-day and 200-day simple moving averages (SMA).

As is often the case with new industries, a benchmark for comparison must first be established before the followers can join the party. This has now happened. Further, as the company and the industry transitions from a developing industry to an established one, more interest from lower-risk investors will begin to enter the picture.

Canopy is trading at a multiple of 35 times last year’s revenues. Taking the past four previous quarters, the multiple declines to 30 times revenues, as the share price has been moving sideways for quite some time.

Given the projected revenues of the company for the 2017 full fiscal year, the current price is a multiple of no more than 24 times. Clearly, investors are purchasing this security for a cheaper multiple as time moves forward.

When considering the cash flow from operations (CFO) and the gross margins, however, the company still has some challenges, as both are negative but improving at a rapid rate.

One of the major challenges faced by the marijuana industry is that part of the revenue recognition must be subtracted to arrive at CFO. Once the product is sold to a customer, the amount is added back.

Given the increase in capacity of many marijuana companies, the legalization of the product will have the potential of drastically increasing both the margins and CFO. Once this is realized, the next stop for shares of Canopy Growth Corp. could be north of $20!

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Fool contributor Ryan Goldsman has no position in any stocks mentioned.

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