Shareholders of Hexo (NYSE:HEXO) are not happy. And for good reason. Since April, the HEXO stock price has dropped from over $8 per share to current levels around $4.50. Like many other companies in the cannabis industry, Hexo is facing some challenges.
If you invest in marijuana stocks, you should have a basic understanding of how they value their inventory of cannabis. For example, say a company has 10 pounds of cannabis in storage and they believe that it is worth $10 a pound. Then the value is $100, and this is considered to be part of the overall value of the company.
Now suppose that the company says a pound of cannabis is worth $12. This makes the value of the cannabis that is in storage increase by 20% to $120. This in turn increases the overall valuation of the company.
The next question is, how does the management know that it is worth $12? Where does this number come from? Is it based on the price that it costs HEXO to produce a pound? Or is it the cost of what it sells for? Is it based on an index? Did they just pull it out of the air?
You need to be very careful because different companies calculate the numbers in different ways and some can be quite subjective. Therefore, two different companies could be giving identical assets different valuations.
HEXO Management’s Discussion and Analysis of Recent Earnings
The management’s discussion and analysis of the company’s most recent earnings release describe in detail how HEXO determines a value for the cannabis it holds in inventory.
Four variables are considered to determine the valuation. These are the average selling price, the yield per plant, the stage of growth, and the amount of wastage.
The average selling price, at $4.95 a gram, is obtained from retail sales. That seems pretty straightforward. The yield per plant isn’t so easy. Plants can yield between 62 and 125 grams. That’s a big difference.
How do they decide on a number to use? The report explains that the numbers are obtained from an analysis of historical results.
The stage of growth is obtained through subjective estimates. Wastage is also estimated and it can be between 0-30%, depending on the stage of the harvest cycle. This a significant difference.
Bottom Line on Hexo Stock
As you can see, a big part of the valuation of a company’s inventory can be determined by subjective estimates. I am not suggesting that Hexo Corp is doing anything wrong. In fact, they seem very forthcoming about their processes and methods.
I just believe that you should have an understanding of these dynamics when you are considering investing in Hexo stock or any other company. You should be aware when things are valued based upon subjective estimates.
If the highest price that you could sell your house at is $1 million, it is worth $1 million. You may say to yourself, “I think my house is actually worth $1.1 million because I like the paint job.” But does this increase the value of your house by 10%? Probably not.
If you want to gain a deep understanding of a company’s valuation, subjective estimates such as these are things that you should consider.
At the time of this writing, Mark Putrino did not hold any positions in any of the aforementioned securities.