We saw large increases in the value of public companies during 2017 in anticipation of the new administration’s proposals to reduce federal regulations, promote growth policies and push for tax reduction. The Dow Jones Industrial Average and the NASDAQ both increased just over 20% during 2017 and the S&P 500 index increased by almost 16% during the year. The Russell 2000 index of small stocks rose 1.6% in 2017. Tax reform legislation was enacted near the end of December 2017 (the Tax Cuts and Jobs Act of 2017). Income tax rate reductions had an immediate, significant impact on the valuation of privately-owned business entities.
Valuation of privately-owned business entities is based on the expectation of future cash flows therefrom. A reduction in expected future expenses, such as income taxes, results in a greater cash flow for the business enterprise. Federal corporation income tax rates were reduced from a high of 35% to a flat rate of 21%. When combined with Arizona income taxes, the maximum overall effective corporate income tax rate changed from 39.5% in 2017 and prior to 26.5% in 2018.
One of the income approaches to valuation is referred to as the single-period capitalization of some form of earnings or cash flows. We generally like to use the expected future cash flows as the measure. In the single-period capitalization of cash flows model, the cash flows expected in the year subsequent to the valuation date are assumed to grow at a constant rate, say 3% per year, into the future. The expected future cash flows are converted to value by dividing the expected cash flows by a rate of return appropriate for the inherent risk in the investment. The formula is as follows;
The following simplified example illustrates the impact of the corporation income tax rate change on the value of the business enterprise. The example is based on the following assumptions.
- The annual rate of return for an investment in the business enterprise of 23% required by the investor.
- The expected annual growth rate is equal to 3%.
- The expected pre-tax income for the year immediately after the valuation date is $500,000.
- Future annual capital expenditures are equal to annual depreciation deductions.
- Estimated future working capital investments are estimated at $20,000.
As you can see, the impact of the change in the effective corporation income tax rates is an increase in value of 23%. The above result is based on a regular corporation (a C Corporation) rather than an S Corporation. A slightly different outcome occurs with respect to S Corporations, although the results also reflect a significant increase in value.
Steve Koons, CPA, ABV, CFF, ASA