A total of 35 states and the District of Columbia have laws broadly legalizing marijuana in some form as of November 2020. This relatively new legalization allows dozens of new companies that specialize in the plant to emerge. Some of those companies have gone public and offer a new investment niche—pot stocks. But how do you know if you are getting a good deal? How are these stocks even valued? If you want to get in on (nearly) the ground floor of marijuana stocks, keep reading. But remember, as with all new industries and new stocks, investing is risky and one act of legislation could render the companies worthless.

What Are Marijuana Stocks?

Most of the products we know and love are owned by publicly-traded companies. The soft drink industry has Coke (KO) and Pepsi (PEP), beer has Anheuser-Busch (BUD) and Molson Coors (TAP), and tobacco has Phillips Morris (PM) and the like. Now that it's legal in many places around the country, marijuana also has companies that specialize in the product. When those companies issue stock, they are considered marijuana stocks.

Growers are just one sub-sector of this industry. These companies specialize in growing marijuana plants. Once harvested, they sell their plants to distributors who are then responsible for everything else down the line. However, they aren't the only companies that specialize in weed stocks. There are also pharmaceutical companies like Vancouver-based Abattis Bioceuticals and London-based GW Pharmaceuticals (GWPH).

In fact, dozens of publicly traded companies have their roots in the marijuana industry. The problem, however, is that very few of these companies have high valuations.

How Are Pot Stocks Valued?

In order to better understand the valuation of pot stocks, we need to know a little bit about how all stocks are valued. When a company plans to go public with their stock, they hire an underwriter—usually huge investment banks like Goldman Sachs—that analyzes the company to determine its worth. From that point, the underwriter works with the company's executives to determine a stock price.

Let’s suppose XYZ Company is determined to be worth $100 million. They want to raise some money, so they go public and plan to sell shares, raising $40 million. Working with the underwriter, they decide to sell four million shares at a starting price of $10 per share. Based on the company’s worth, the number of shares, and the portion of the company that will be made available, they reach a stock valuation of $10 per share. Now keep in mind that as soon as the company goes public, that price starts to move—some based largely on speculation—and the valuation changes.

The problem we run into with marijuana stocks is that very few cannabis companies are worth $100 million. In fact, there aren't many that are worth even close to that. For instance, Abattis Bioceuticals has a market capitalization of just $1.19 million. This leaves the problem that most marijuana stocks are traded as over-the-counter (OTC) and they're barely regulated.

Problematic Pot Stock Valuations

Buying a stock with a decent valuation means a couple of different things. First, you need a company with a long history. These companies have had time to grow and perfect their business models. The marijuana industry is simply too young to allow for that. The other way to buy stock with a decent valuation is to go with a company that has specializations outside of the marijuana market, as with GW Pharmaceuticals They rely heavily on marijuana—and incorporating the THC into various other pharmaceuticals—but it is not their only area of expertise.

What we are left with are penny stocks. These are stocks that trade at less than $1 per share—some even less than 1 penny per share. This leaves the investment niche open to fraud.

There are a few key problems with penny stocks. First, they aren't listed on any major stock exchange, which leads to very little oversight. But that in and of itself isn’t the problem. The bigger issue is that in order to get to the penny stock level, the company either starts out at a higher valuation and its stocks steadily decline in value until they are stuck at a valuation of less than $1 per share, or the company has a market cap that is too low for the number of shares available. Either way, it is considered to be at risk of dying off, possibly soon.

Where Is This Heading?

According to most theorists, the legalization of marijuana is just beginning. As the years roll on, it is a largely held belief that more states will relax their laws and allow recreational use of the drug. This means that the companies already in the game will be able to sell to a larger market. It also means that there will be more competition, which is a good thing.

While countries like Canada and Uruguay have fully legalized marijuana, individual states are moving slowly toward that direction. As of November 2020, 35 states and the District of Columbia legalized weed to some degree. But don't expect much movement from the federal government just yet, where it remains a controlled substance.

The Bottom Line

Marijuana stocks can be quite lucrative for the savvy investor. But you have to be able to weed out poor performers from the companies that will still be around and flourish when the laws are relaxed. You may want to look over the Viridian Cannabis Industry Report and Stock Index as a good starting point.

For those who hope to capitalize on the marijuana industry and reduce their risk, there are dozens of industries whose reach extends beyond pot but are still related to the plant. Agriculture companies, tobacco companies, and pharmaceutical companies all stand to gain if marijuana becomes legal in all 50 states.