Recent discussions by the new administration regarding changing corporate and individual tax rates got me thinking about how different income tax rates can affect the value of a company. For example, I ran some numbers with the following assumptions. The current effective tax rate on a pass-through company’s earnings at the individual level is 38 percent and the new rate will be 30 percent. This hypothetical company creates $1,000,000 in earnings before interest, taxes, depreciation and amortization, deducts $100,000 in depreciation, and has $20,000 in interest expense. The company distributes to the shareholders amounts equal to the shareholders tax liability; therefore, I will tax-effect the earnings of the pass-through company as if it paid taxes, which I consider a cash flow item. And finally, I assume the valuation multiple based on last twelve months of EBITDA is 4.0x.
Under the above assumptions, net income will increase from $545,600 to $616,000 due to the proposed changes in the tax law and since EBITDA is an economic benefit before the application of taxes, it remains unchanged at $1,000,000.
Since EBITDA remains unchanged, but the business owner’s net income increases, my theory is that, all else being equal, valuation multiples are required to increase. The following example illustrates my argument.
As I present above, if the valuation of the subject company remains at $4,000,000, the business owner’s implied return increases from 14% to 15.8% (using net operating profit after tax as a proxy to cash flow). I would argue that the market’s expectation of risk for the company is at least equal to the historical expectation of risk under a low tax environment; therefore, I should expect to see returns equal to 14 percent in this example.
As presented above, I have adjusted the multiple to arrive at a valuation of the subject company that matches the risk of the cash flows or 14 percent. The new valuation increased by $500,000 or 12.5 percent.
I expect this phenomenon to apply to publically traded companies also. In my example I use a popular valuation metric for public companies, the price to earnings ratio (“P/E”). A P/E ratio of 10 ($10 price to $1 of earnings) assumes a capitalization rate of 10 percent. Using an effective tax rate of 32 percent as the current tax rate and 15 percent as the new effective tax rate, the earnings of the company will be $1.25 compared to $1.00. To maintain the same capitalization rate of 10 percent, the price of the public company is required to increase to $12.50 or an increase of 25 percent. In my opinion, some of the recent move in the stock market has already incorporated this issue in the expectation of tax law changes.
Mike Metzler, CPA, ABV, CMA, CGMA, ASA, Manager
EBIT – earnings before interest and taxes
EBITDA – earnings before interest, taxes, depreciation and amortization
EBT – earning before taxes
MVIC – market value of invested capital (the value of a company as a whole)
NOPAT – net operating profit after tax (a proxy for free cash flow to the firm)