In May, I had the opportunity to attend the annual Fair Value Conference organized by the American Society of Appraisers (ASA) in Los Angeles. As one may expect, a hot topic at the conference was the impact of the Tax Cuts and Jobs Act (TCJA) signed into law by the Trump Administration on December 22nd of 2017.
Of particular interest to those of us in attendance was the reduction of the federal corporate tax rate from 35% to 21%. After accounting for the additional layer of taxes levied by individual states, the blended tax rate decreased from approximately 40% to 25.7% for American companies, a total decrease of approximately 14%.
An interesting question was posed by some attendees: how quickly should the value increase be recognized by a business following the TCJA? Before we get into answering the question, let us first pose a more high-level question: are companies more valuable in 2018 than they were in 2017 before the TCJA? For most businesses, the answer is “yes”.
The Impact of Taxes on Valuation
The impact of taxes plays a critical role when valuing a business as a going-concern. The “value” to the shareholders of any business is ultimately derived from the present value of the future cash flows. The impact of taxes can clearly be seen when valuing a business with an income approach, such as discounted cash flows (DCFs), but multiples observed though a market approach also reflect the future income to the business.
For example, a business with higher expected future cash flows will trade at a higher EBITDA or revenue multiple than a company with lower expected future cash flows. Below, we see two DCFs, the first using the reduced 25.7% blended tax rate, and the second using the legacy 40% blended tax rate. Each of the DCFs are calculated with the same projected EBIT and adjustments to cash flows; however, the value of the company utilizing the new tax rate is approximately 20% higher than with the legacy rate.
When Was the Value Increase Recognized?
Upon considering this “immediate” increase to value, one may wonder why stock prices in the public markets did not immediately increase when the reform passed. The answer to this is found in how investor’s anticipation of market-impacting events, such as a new tax policy, are reflected in the overall value of the market over time.
For reference, consider the S&P 500 graph below. In the runup to the November 2016 Presidential election, one of the major items on presidential candidate Donald Trump’s agenda was a reduction of the federal corporate tax rate. Upon his election, investors began to consider a possible future decrease in the corporate tax rate as a driver of current value. As a result, stock prices began to gradually increase in anticipation of tax reform. As anticipation for tax reform grew in the second half of 2017, stock prices increased even further. Once the details of the TCJA were announced, and investors better understood the benefit the TCJA would have on corporate earnings, there was a further spike in equity prices. This growth in equity prices continued through January of 2018 until investors, sensing an overheating market, pulled the reins on the market, effectively halting price growth.
From an appraiser’s perspective, the impact of the TCJA was more abrupt. As details of the tax cuts were unknown throughout the majority of 2017, appraisers used legacy tax rates up until the TCJA was signed. This resulted in drastically different enterprise values for some companies when observed on a year over year basis. Thus, the impact of the new tax legislation on companies valued by appraisers, such as Intrinsic, was sudden in contrast to its smoothed impact on publicly-traded entities.
Conclusion and Application to Common Valuation Types:
ASC 350 (Goodwill Impairment): Under U.S. GAAP, impairment occurs when the carrying value of a business exceeds the fair value of a reporting unit. Fair value is typically triangulated using a combination of both market and income approaches; therefore, the fair value of a reporting unit will be higher as a result of the TCJA. The lower tax rate could hypothetically save a company from impairment when utilizing the updated tax rate.
ASC 805 (Purchase Price Allocation): Due to the lower corporate tax rate, we expect to see higher deal values in 2018 versus similar transactions in 2017 as companies pay more for the higher expected cash flows. While that, in a vacuum, would cause an increase to the value allocated to goodwill, a lower tax rate will also cause the identified intangible assets to increase in value. For example, when valuing a tradename using the relief from royalty approach, the concluded value is the present value of the after tax royalty stream (i.e., lower tax rate = higher royalty stream to the intangible asset).
IRS 409a: All else equal, the concluded value for 409a valuations will be higher in 2018 than in 2017. This will result in options being issued at higher strike prices.
Are you curious about the impact that tax reform had on your business? We would love to connect! Feel free to contact me at Luke@Intrinsicfrim.com.
*Disclaimer: the purpose of this blog is to provide the reader general education and information about taxation and economics. It should not be construed as financial or investment advice by Intrinsic, LLC, or any of its partners or associates. Each valuation is unique and requires a thorough analysis of a company’s historical and current financial situation, in-depth discussions with management, analysis of any other material information, a written statement of work, and a payment of fees.