Aurora Cannabis (NYSE:ACB), Canopy Growth (NYSE:CGC), and Tilray (NASDAQ:TLRY) combined made less than $150 million in the last quarter, yet all three marijuana stocks have market caps of at least $6.7 billion, with Canopy's market cap a whopping $16 billion. We're talking about stratospheric price-to-sales (P/S) ratios for all three stocks.
My Motley Fool colleague Sean Williams even wrote recently that "no sane investor can justify" Tilray's valuation after its latest quarterly update. Sean is going to think I've gone crazy, but I think it's possible that Tilray isn't overly expensive.
Actually, I think Aurora, Canopy Growth, and Tilray could even be big-time bargains right now. Absurd? Insane? Maybe, but just follow my train of thought here.
A view on valuation
I don't think any stock, regardless of the industry, should be valued on historical sales or earnings. True valuation actually hinges on future sales and earnings prospects.
So why do investors rely on historical valuation metrics so much? Because they help investors get a feel for what future results might look like. The problem for rapidly growing companies is that historical performance doesn't provide much benefit in guesstimating future sales and earnings.
To assess the valuation of high-growth stocks, investors either consciously or subconsciously attempt to do two things. First, they try to determine what the total addressable market for the business in question. Second, they make an effort at guessing how well the company can execute and capture part of that total addressable market.
Here's the important thing to note: The current and historical performances of a given stock often have little bearing on either of these two factors. I think that's definitely the case with Aurora Cannabis, Canopy Growth, and Tilray. What we really need to focus on are those two key factors of the total addressable market and the abilities of the companies to successfully compete in that market.
A really big addressable market
Estimates for just how big the global marijuana market could become vary quite a bit. Let's start with the number that's probably tossed around the most -- $150 billion.
This figure stems from a United Nations report. It primarily includes estimated illegal sales of marijuana. We can reasonably assume that the majority of these sales are for recreational use of the drug. The problem with using the $150 billion number is that only two countries have legalized recreational pot so far.
However, 10 U.S. states have legalized recreational marijuana. More big states are likely to follow in their footsteps in the near future. Although Aurora, Canopy, and Tilray can't enter the U.S. market while marijuana remains illegal at the federal level, the chances of changes to federal laws appear to be better than ever.
We can't overlook medical marijuana, though. Major countries across the world have legalized medical cannabis, notably including Germany and the United Kingdom. Tilray CEO Brendan Kennedy said in his company's Q4 conference call that the number of countries allowing the legal use and sale of medical cannabis could "grow to 50 or 60 by the end of 2019."
There's also a big opportunity in the U.S. now that hemp has been legalized. Cannabis market research company Brightfield Group projects that the hemp-based cannabidiol (CBD) market could reach $22 billion by 2022. That's a much rosier forecast than others, though. Still, the potential for a multibillion-dollar U.S. hemp CBD market doesn't seem unrealistic.
I spoke last year with Roy Bingham, the CEO of cannabis market research company BDS Analytics, about his take on the potential global cannabis market size. He thought that the market could easily top $100 billion over the long run, and that number excludes Asian countries. Cowen analyst Vivien Azer projects that the U.S. cannabis market by itself could hit $80 billion by 2030.
For what it's worth, Constellation Brands (NYSE:STZ) used an estimate that the global cannabis market could top $200 billion within the next 15 years in its decision to invest in Canopy Growth. And Constellation ponied up $4 billion, so you'd think that the big alcoholic beverage company did plenty of due diligence in its projections.
Arguments for Aurora, Canopy, and Tilray
Based on all of the estimates we've discussed, let's assume the global cannabis market size in 2030 will be in the ballpark of $100 billion. What market share would it take for the three biggest Canadian marijuana growers by market cap to justify their current valuations?
If we use a P/S ratio of five (which is roughly in the middle of the average P/S ratios for the alcoholic beverages and tobacco industries), Aurora Cannabis would need to capture a market share of around 2%. Canopy Growth would need to snag a little over 3% of the market. Tilray would need to grab a market share of a little under 1.5%.
Can these three companies achieve these levels? There are pretty good arguments to be made that Aurora, Canopy, and Tilray can easily exceed those market share percentages.
All three companies already have solid international operations. Aurora, Canopy, and Tilray are the leaders in Germany, which boasts the biggest legal marijuana market outside of the U.S. My view is that all three companies can leverage their German operations to win in other European markets. Canopy and Tilray are already moving into the U.S. hemp market. Aurora probably won't be too far behind its rivals.
Canopy has its relationship with Constellation working in its favor. Aurora is working hard to line up partners, recently tapping billionaire investor Nelson Peltz as a strategic advisor to facilitate deals. Tilray has teamed up with several big companies: Anheuser-Busch InBev, Authentic Brands Group, and Novartis.
Sure, there are a handful of other companies that could be key contenders in the global cannabis market in the future. Cronos Group, for example, stands out because of its partnership with tobacco giant Altria. But my take is that Aurora, Canopy, and Tilray are in pretty good shape to be among the top industry leaders.
Constellation Brands thinks that Canopy could garner as much as 15% of the global cannabis market. If that projection is on target, it doesn't seem unreasonable to anticipate that Aurora could claim a 10% market share, with Tilray coming in with at least 5%. Using these guesses, Aurora Cannabis, Canopy Growth, and Tilray could be potentially worth at least triple their present valuations by the end of the next decade and perhaps a lot more.
I'll be the first to admit that there have been a whole lot of assumptions made. But that's a necessary evil in trying to determine the valuations of stocks in fast-growing markets. It's quite possible that there are critical flaws in these assumptions that blow apart the theory that Aurora, Canopy, and Tilray aren't ridulously expensive right now.
However, some of the assumptions could be way off and still allow these three top marijuana stocks to have a lot of room to run. Aurora Cannabis, Canopy Growth, and Tilray just might look like big-time bargains in hindsight a few years from now. And some "crazy" investors today could be laughing all the way to the bank.