How to Think About Corporate Tax Reform
publication date: Nov 26, 2017
author/source: Brian Nelson, CFA
Image Source: DonkeyHotey
Donald Trump and team are working hard to “Make America Great Again,” and lowering tax rates on corporations is a key initiative. Nobody knows for sure whether such efforts will come to fruition, but knowing how to use our research and understanding the fair value estimate range puts you ahead of the crowd, if it hasn’t already.
By Brian Nelson, CFA
It’s on everyone’s minds these days. What is it? Taxes.
On November 16, the House gave the thumbs up to what the New York Times described “as the most sweeping tax overhaul in three decades.” The bill aims to cut the corporate tax rate to 20% from 35%, and reduces the number of tax brackets from seven down to four: 12%, 25%, 35%, and 39.6%. The Senate will be looking to get its version of the bill passed after the Thanksgiving holiday, but it may be too early to say whether the bill in its existing form will get the job done.
Some are saying the proposed new tax legislation might actually raise taxes on lower-income Americans within just a couple years, and while the “real” story varies depending on which side of the aisle you’re talking to and what assumptions you make, we’re optimistic tax reform has a real chance, though we note Congress has a way of stopping itself dead in its own tracks, much like recent efforts with respect to healthcare reform. Republicans, in any case, would like a bill on President Trump’s desk before Santa arrives. That might be an optimistic timeline, but we’ll see. We’d be fools to try to handicap the political environment, but we can’t ignore it either.
Our efforts continue to be spent on thinking about how any changes in the tax code may impact corporate valuations. Our fair value estimates across our coverage currently reflect what we consider to be a base-case valuation for the respective stocks, and we provide a fair value estimate range, in part for you to ascertain how items like a permanent reduction in the corporate tax rate or permanently low discount rates (the 10-year Treasury) might impact a company’s valuation. You might consider the upper bound of a fair value estimate range as a new “base case” in the event corporate tax rates are reduced to 20% and interest rates remain artificially low into perpetuity.
Some companies might even see larger point fair value estimate adjustments and some smaller, but this is one of the key benefits of having access to our discounted cash-flow models. You can enter your own cash tax rate assumption and see how that impacts the valuation of the equity you’re interested in. The change will reflect the net impact of higher future free cash flows, offset in part by a higher after-tax cost of debt, where applicable. At this point, we’re putting the odds of meaningful corporate tax reform at 50/50, as we’re not partial to any information that would lead us to believe chances aren’t even. A handicapper using history as his or her guide might put chances at 25%, however, given the recent failure of healthcare reform.
We’re anxiously awaiting the outcome, but we’re not getting too excited. The market has been expecting “something” with respect to changes in the tax code for some time. We may make changes here and there to our point fair value estimates in our coverage universe in the event corporate tax reform eventually does become law, but for the most part, we think our fair value estimate ranges continue to capture what they are supposed to. Our base cases reflect forecasts that capture a favorable political and economic environment to corporations, the high end of the fair value estimate ranges might capture a continuation of ultra-low interest rates and beneficial corporate tax reform, and the low end of the fair value estimate ranges might signal a deteriorating political environment and a recession that nobody is currently predicting.
During the past year, we’ve given many companies cost-of-capital benefits as a result of their respective all-equity structures to better reflect what we’d describe as lower financial/bankruptcy risk, particularly in the event of the current ultra-low interest rate environment. Frankly put, some of our cost-of-capital assumptions had been too high as a result of the Fed seemingly taking its queue from the stock market more than anything else. We’re still mindful of the potential rising capital costs for more leveraged entities in the event operational cash-flow sours during tough times, of course, but the Fed isn’t moving as quickly as we would have thought given stock market prices and the strength of the US economy. It couldn’t have been 15 years ago when a prudent saver could get a certificate of deposit interest rate of 7%. Now look at how much risk one has to take on to get that yield!
What’s the Fed doing? It has almost backed itself against the wall, making it necessary to support the stock market just to keep savers from losing years and years of income. Still, the recent past has shown the Fed doesn’t have to raise rates aggressively. There’s a lot going right in a lot of places in the economy right now, especially unemployment--and the wealth effect of the stock market has been tremendous on consumer spending. Jokingly, I’m hearing that people are buying Teslas after having cashed in their Tesla (TSLA) stock. Why should the Fed ruin a good thing? Of course, all good things eventually come to an end, and the savviest of investors are the ones that are most worried, but who wants to be responsible for sending the market into a tailspin? The Fed certainly doesn't.
In any case, the answer to how corporate tax reform may impact the valuation of companies in your portfolio is in each company’s 16-page report, as it relates to the high end of the fair value estimate range, which we think is a good estimate in the event corporate tax reform comes to fruition. You can download our latest weekly data update here, which always includes the upside and downside cases, and please let us know if you’d like to use our discounted cash-flow models to put in your own cash tax rate assumption to evaluate the impact. We think this is one of the biggest benefits of our service. Within the discounted cash-flow model, you can assess and consider probabilities with the simple stroke of the keyboard. Having access to our discounted cash-flow models is a key part of the financial advisor level and institutional level plans.
As a side note, Marketwatch has a great calculator if you are interested in seeing if you’ll pay more or less under the Trump tax plan, but take everything with a grain of salt, of course. Here >>