A bubble is most often defined as a period in the investment cycle when investors behave in an emotional manner, bidding up the price of an asset to such a level that it actually sells for substantially more than its intrinsic value. Like kids blowing bubbles into a glass of chocolate milk, investors may feel that the fun will go on forever. In almost all cases, however, the natural tendency is for bubbles to either deflate gradually or pop altogether.
To rationally consider shares in Canada’s marijuana stocks, we must first properly evaluate the situation.
Over the past month, shares of Canopy Growth Corp. (TSX:WEED), Canada’s largest marijuana grower, have increased by more than 100% after closing at slightly less than $40 per share on January 8, 2018. Clearly, investors have lost sight of the fundamentals of the business and the timing of things.
Although legalization is scheduled for halfway through the year, investors need to begin asking some difficult questions.
What is the P/E ratio, and what is the appropriate P/E ratio to pay for this stock?
Unfortunately, over the past four quarters, Canopy has lost money in each and every quarter, totaling losses of $0.47 per share. In addition, the company has burned through $22 million in cash over the past six months. On the cash flow statement, the cash flow from operations (CFO) for the entire 2017 fiscal year (ending March 31, 2017) is negative $27 million. Clearly, investors believe that there is potential in the future, but with no profit or even positive cash flow, it becomes very difficult to analyze this company.
So, what is this potential? Is it a patent? What is the product differentiation?
Unfortunately, there is no product differentiation for any producer, and there are no patents that would separate any marijuana company from the pack. The industry is composed of a number of companies that are competing over who can grow weed at the lowest cost. This product is really no more than a commodity.
As a reminder, many provinces allow for plants to be grown by individuals for purposes of personal consumption only.
Why have share prices increased so drastically in this industry?
As is sometimes the case, certain investors behave irrationally, and instead of being caught with their pants down, the stock goes even higher as the irrational behavior continues. In the process, the short sellers are forced to cover their positions and accept their losses, as the prices of shares in the industry continue to increase.
As Yogi Berra would say, “It’s déjà vu all over again.” In the year 2000, many investors saw this situation unfold in very much the same way in the technology industry. Companies with no way of justifying their share prices traded at exorbitant prices. At a price of almost $40 per share, Canopy has produced revenues of $57.85 million over the past four rolling quarters. With 168 million shares outstanding, if revenues were equal to profits, then there would be a total profit of $0.34 per share, and the P/E would be in excess of 115 times. Unfortunately, this is not the case. The situation is that a company, with trailing revenues of $57.85 million, has a market capitalization of more than $7 billion.
Which bubble will pop first: marijuana or cryptocurrency?
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Fool contributor Ryan Goldsman has no position in any of the stocks mentioned.