Friday, October 12, 2018

The Impact of Tax Law Changes on Business Valuations: Five Takeaways Almost One Year Later

James A. Gravitt, CPA, CBA, ABV, CFE
Author position
Vice President, Business Valuations

While business appraisers have learned a lot about valuing privately held businesses under the new tax law[1] (“the TCJA”), it would be a mistake to say that we have overcome all of the challenges. Here is an overview of the TCJA and how it has affected business valuation (so far).

The TCJA has many provisions that are still being fleshed out in the form of IRS regulations as this article is written. But here are the TCJA’s most significant provisions for corporations:

  • The highest marginal tax rate was cut from 35% to 21%.
  • Provisions affecting pass-through entities were changed significantly.
  • Net operating losses now can be carried only forward, not carried back as before.
  • Business interest expense deductions were limited for larger ($25 million revenue) businesses.
  • Increased/accelerated deductions for depreciation were enacted, but are not permanent.

And here are five takeaways – what we know and what we don’t know as of late 2018:

  1. Estimated earnings have gone up – but not across the board.

    Straightaway, reducing taxes by $14 on $100 of pre-tax earnings would increase the value of a company by 22% using an earnings-based valuation method where value equals an earnings measure divided by an investor’s required rate of return (minus an expected growth rate – a capitalization rate). 

    Here is an example:
     

      Before TCJA After TCJA Difference
    Pre-tax earnings $100 $100  
    Less taxes (35) (21)  
    After-tax earnings 65 79 22%
    Capitalization rate 15% 15%  
    Value indicator $433 $527 22%


    To some extent, this added value is currently reflected in public stock markets – stock prices have increased significantly since the tax cuts were anticipated following the 2016 presidential election. But not all companies and industries are equally affected by the tax rate reduction. Those that were paying taxes at something close to the statutory rate have benefitted more than those paying at a lower effective tax rate due to industry-specific deductions and tax credits (some of which were modified or removed; details are beyond the scope of this article). The implications for an individual company can vary greatly.  

  2. Cash-flow modeling has become more complex, and the discounted-net-cash-flow method may take on more importance as a result.

    Greater complexity in estimating future net cash flows is due to possible changes in management intentions as a consequence of the TCJA. The question is what management plans to do with any tax savings. Savings may not be automatically distributed to shareholders; instead, they may be used to purchase fixed assets, to pay higher wages, to repay debt, to lower prices, or to pay suppliers. Also, while some TCJA provisions are permanent, others (such as the accelerated depreciation deduction noted above) are not. Overall, the TCJA has the effect of making a multi-year discounted net cash flow model more suitable than a single-period capitalization model for valuing some businesses. 

    An additional consideration is in the long-term growth rate assumption that is part of a discounted-net-cash-flow-based value indicator. The higher the expected long-term growth rate, the lower the capitalization rate for the terminal year of a discounted net cash flow model, and the higher the resulting value. The long-term growth rate can be affected by higher capital expenditures made to increase production capacity and efficiency, thus accelerating long-term growth. The TCJA contains provisions for higher and accelerated deductions for capital outlays, potentially leading to greater investments in productive equipment and technology. 

  3. Valuing pass-through entities has become more nuanced.

    The TCJA established a new system for taxing pass-through entities or PTEs (S corporations, limited liability companies, etc.). The relative after-tax benefit of holding an equity interest in a PTE has been materially reduced because of the smaller gap between the two types of tax rates resulting from the TCJA. As part of the PTE tax relief, reasonable owner/officer compensation is considered in the computation of the new Qualified Business Income (QBI) deduction. This may result in more scrutiny of economic compensation when valuing an interest in a PTE. 

  4. Expected rates of return may have changed.

    The mix of debt and equity capital is an important valuation consideration, since (under the income approach) a company’s enterprise value is determined by dividing a numerator (cash flow to invested capital – debt and equity) by a denominator (cost of debt and equity capital). Just as estimated net cash flow has been affected (mostly positively) by the TCJA, a company’s estimated cost of capital may need to be adjusted higher (having a negative impact on value). This is due to the increased after-tax cost of debt – there is less tax savings from interest deductions due to the lower tax rate and a deduction limitation for larger companies (sales over $25 million). Given this, companies may be inclined to finance their operations with a higher mix of equity than before the TCJA. Since the cost of equity capital is higher than the cost of debt capital, this again will serve to increase the cost of capital.

  5. The Impact on market approach methods is still murky.

    Business appraisers generally consider two market approach valuation methods. 

    The guideline public company method is based on the trading prices of publicly held stock as a multiple of various financial metrics (sales, earnings, assets, etc.). 

    The guideline private transactions method is based on the sale of privately held companies as a multiple of their financial metrics. 

    The TCJA’s effect on the usefulness of this data for valuing businesses is not yet clear.

    While the trading value of many public companies has increased, valuation multiples based on trailing after-tax earnings measures may yet need to catch up. This is because (as after-tax earnings under the TCJA increase) trailing earnings will tend to be lower (making multiples higher) than future earnings due to lower tax rates alone. This analysis assumes that the stock price doesn’t change, as the positive impact of the lower tax rate has already been factored in. This anomaly will become less of a problem in the future, as more quarters of post-TCJA earnings will be factored into the multiple.

    The question remains as to how market multiples will change, if at all, following the TCJA. Will investors require a higher or lower rate of return on these more profitable companies, thus affecting public com­pany trading multiples? Using the guideline public company method will automatically factor these con­siderations into the valuation, because the data is current as of the valuation date.

    These same considerations also affect the guideline private transactions method. Assuming no change to investors’ return expectations for privately held companies after the TCJA, it may be appropriate to adjust the subject company’s historical after-tax earnings for the impact of estimated taxes under the new law. But an easier way to address the issue would be to use a multiple based on a non-tax-affected metric such as sales or pre-tax earnings. Until there are several years of post-TCJA private transactions data available, the effect (if any) of the TCJA on private company transaction multiples will be unknown.

    So what?

    The effects of the TCJA on business valuation are evolving. But, clearly, not all companies have benefited equally. Generally, asset-intensive, low-debt companies that had high tax rates under the old tax law will tend to benefit more. Some companies that may have been paying a low effective rate before, and that are highly leveraged, will benefit less from the lower tax rates. When considering the valuation of a specific company, business appraisers need to understand the subtleties of the TCJA and work closely with the subject company’s management and advisors to obtain a credible valuation result now that the tax landscape has shifted significantly.

    © 2018 J.J.B. Hilliard, W.L. Lyons, LLC. You may not reproduce or distribute any part of this newsletter without Hilliard Lyons’ prior written consent. We believe that the information in this newsletter is reliable, but we do not guarantee its accuracy, and it may be condensed or incomplete. This newsletter is for information purposes only, and is not intended as financial, investment, legal, or consulting advice.

 

[1] The Tax Cuts and Jobs Act, passed on December 22, 2017, and effective for 2018.