AICPA 2018 Forensic & Valuation Services Conference in Atlanta, GA
On Monday, November 5th, I spoke on a panel with Bill Dameworth and Dr. Ashok Abbot. Our topic was “Active Passive Appreciation — Current Update.” Overheads are available here. All three of us have previously written and spoken on this topic.
On Wednesday, November 7th, I spoke again with two colleagues, Jim Hitchner and Robert Reilly. Our panel was called the “Valuation Tax Panel,” which provided three perspectives on the impact of the 2017 Tax Cuts and Jobs Act (TCJA) on business valuation. Overheads are available here.
Hitchner and Reilly addressed some of the more detailed provisions of the new tax law. My role was to address what happened to valuation multiples and to warn business appraisers not to lose sight, amidst all the complexities, that value has changed positively. This post provides a brief summary of my comments.
C Corporation Tax Rates are Lower
While complexities in the new tax law abound, the fact is that the marginal corporate tax rate for C corporations has been lowered from 35% to 21%. Blended federal and state rates, therefore, changed from the order of 38% to about 25%. At the most basic level, other things being equal, taxable C corporations are generating more after-tax cash flow under the new law than the old.
As a result, C corporations and other entities valued as if they were C corporations are worth more now than before.
Impact on Valuation Multiples
To be discussed shortly, assume for now that the TCJA had no immediate impact on after-tax valuation multiples. That makes sense because the immediate impact of the tax cut was/is, other things equal, to increase after-tax earnings – same earnings, less taxes, and more after-tax earnings.
What is the impact of the TCJA on after-tax multiples? There is no immediate or direct impact on valuation multiples.
Recall the basic valuation equation:
If earnings rise and the multiple stays the same, then value rises. That’s intuitively understandable.
What about the impact on total capital measures? We have to think a bit more. The bottom line is that there is no immediate impact of the TCJA on pre-tax income, Earnings Before Interest and Taxes (EBIT), or Earnings Before Interest, Taxes, Depreciation, and Amortization.
But we know that value will increase because of the impact on after-tax earnings. We can look at this in terms of the basic valuation equation.
Let’s look at EBIT and the impact of the TCJA on EBIT multiples in a simple example. Assume that pre-tax earnings are $5.0 million, there is $10.0 million of debt, and the pre-tax cost of debt is 6%. Further, assume that the blended federal and state tax rates are 38% and 25% before and after the TCJA. Further, assume that the market price/earnings multiple (p/e) on after-tax earnings is 10.0x. Finally, assume for the moment that there is no change in that multiple as result of the TCJA.
We note a few things:
- Taxes are down, and after-tax earnings increase 21%.
- The market value of equity, assuming a constant p/e of 10x, also rises 21%.
- Enterprise value, which is the sum of market value of equity and debt (assume at market), rises by the increase in equity, or by a total of 15.9%. This is less than the increase in MVE because debt remained the same.
- For all of this to work, the EBIT multiple, which was 7.3x under the old tax law, must rise to 8.5x to account for the increase in market value of equity.
Impact on Valuations
We had a December 31, 2017 valuation for a recurring client, a C corporation. The client is a large and profitable business. We have had a guideline public company group for many years. The client company fits well within the guideline group based on size and earnings.
After-tax earnings were expected to rise substantially for our client, just as they were rising for the companies in the guideline public company group.
The bottom line is that the full amount of lower than expected taxes in 2018 and beyond were incorporated into the valuation at year-end 2017, and value rose significantly as a direct result of the TCJA. Of course, as with any valuation at a point in time, many things were going on and we took them into account. However, the impact on value based solely on the TCJA was readily apparent.
Unfortunately, I’ve seen a number of appraisals performed by others since the TCJA where, it seems, the appraisers were reluctant to recognize the value-impact of the tax cut.
My message to the appraisers at the AICPA Forensic & Valuation Services Conference was not to be afraid to reflect the impact of the tax cuts into value. The public markets are doing so, and private company transactions are reflecting the changes.
So don’t miss the forest for the trees. Don’t get bogged down in the complexities of the TCJA and overlook the basic fact that the change in tax laws has increased equity values in both the public and private markets.
The discussion in this post may seem obvious to some or many. However, I’ve been accused of delighting in pointing out the obvious. No apologies.
Until next time, be well!
New Book on Buy-Sell Agreements
The drafting of a new book on buy-sell agreements is complete. We sent the draft to a number of external reviewers yesterday and the publication is coming soon. The working title is Buy-Sell Agreement Handbook for Attorneys. I am not an attorney. As always, I write based on my experience as a businessman and valuation guy.
My previous books on buy-sell agreements have been written from the perspective of business owners as in the title of the most recent book: Buy-Sell Agreements for Closely Held and Family Business Owners. Attorneys were, thankfully, one of the bigger markets for this book.
Many times, however, attorneys have said to me, in effect, “Chris, we like the ideas in your book. Do you have some template language to help us implement them?”
Until now, unfortunately, the answer was a “Not yet.” Now, this new book will contain detailed template language for several valuation processes for buy-sell agreements. I’m excited to get it to the point of making it available to attorneys, business appraisers, financial planners and, yes, business owners.
If you want to be notified when Buy-Sell Agreement Handbook for Attorneys becomes available, give me a quick email and we will put you on the list at firstname.lastname@example.org.