As of Jan. 8, 2018, 30 states and the District of Columbia currently have laws broadly legalizing marijuana in some form. Four more -- Michigan, New Jersey, Rhode Island and Vermont -- are expect to legalize cannabis this year.

This relatively new legalization has allowed 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?

Any product you can imagine has a publicly traded company behind it. Soft drinks have Coke (COKE) and Pepsi (PEP), beer has Anheuser Busch (BUD) and Molson Coors (TAP), and tobacco has Phillips Morris (PM) and the like. Now that it is 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 the plants, and after harvesting, they sell them to distributors who are then responsible for everything else down the line. However, those are not the only companies that specialize in weed stocks. There are also pharmaceutical companies like Vancouver-based Abattis Bioceuticals Corp and London-based GW Pharmaceuticals (GWPH).

In fact, there are dozens of publicly traded companies that 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 pot stocks' valuation, we need to know a little bit about how all stocks are valued. 

When a company plans to go public with their stock, they will hire an underwriter. These underwriters, usually huge investment banks like Goldman Sachs, analyze the company to determine its worth. From that point, the underwriter will work with the company executives to determine a stock price.

Let’s suppose that XYZ Company is determined to be worth $100 million. They want to raise some money, so they go public and plan to sell shares and raise $40 million. Working with the underwriter, they decide to sell 4 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 have reached 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 hardly any of these companies are worth $100 million. In fact, very few are worth even close to that. For instance, the aforementioned Abattis Bioceuticals has a cap of just $1.19 million. This leaves the problem that most marijuana stocks are traded as Over-The-Counter (OTC), and are barely regulated.

Buying a stock with a decent valuation means a couple of different things. First, you will often need a company that has 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 (GWPH). They heavily rely 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 dozens of penny stocks (stocks that are trading at less than $1 per share, some at less than 1 penny per share). This leaves the investment niche open to fraud, and many of people have already lost money by investing in these stocks.

The problem with a company that has a stock valuation that falls into the category of penny stocks is that they are not listed on any of the major stock exchanges, leaving 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 and more states will relax their laws and allow recreational use of the drug. This means that those 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. (With competition, the solid companies get stronger as the weaker companies go out of business.) However, there will likely be no new news in the marijuana legalization department until the outcome of the 2016 elections is known. At that time, the public will be aware of which states are being added to the list of pot friendly states, and these stocks may start to rise in value.

The Bottom Line

For the savvy investor, marijuana stocks can be quite lucrative. But first you have to weed out those that are performing poorly, and make an educated guess on which ones will still be around and flourishing as the laws are loosened. To start, you may want to look over the Viridian Cannabis Industry Report and Stock Index.

For those who hope to capitalize on the marijuana industry, but would prefer to reduce their risk, there are dozens of industries related to the pot industry, but have reaches far beyond. For instance, agriculture companies, tobacco companies, and pharmaceutical companies all stand to gain if marijuana becomes legal in 50 states.

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