I’m sure you’ve experienced, like I have, times in your life when, things just aren’t the same anymore. Some examples might include:
- Transitioning from kindergarten to first grade
- Transitioning from high school to college
- Working through the grief resulting from the death of a parent
- Dealing with the long-term impact of an injury
On a lighter note, as a kid and a young man, I was what I call a “half-way athlete.” By “half-way” I mean that I was pretty decent at a number of sports. While I was never a top-flight competitive athlete, I could hold my own in quite a few sports – baseball, basketball, softball, bowling, ping-pong, and volleyball. Somewhere in my mid-thirties, I realized I was no longer a half-way athlete in any sport. To be half-way decent at handball, for example, I had to work at it regularly, and I ceased to be half-way in many others. Why? I realized that things just weren’t the same anymore.
The Tax Cut and Jobs Act of 2017
In the valuation world, we have experienced virtually constant marginal federal tax rates since 1988, when the corporate rate was lowered from 40% to 34%, and 1993, when the rate was set at 35%. Combine the marginal federal corporate rate with deductible state taxes on the order of 6%, and appraisers have been using blended corporate federal tax rates of 38% to 40% for many years.
For about 30 years, appraisers have been on the long horizontal portion of the chart until President Trump signed the Tax Cut and Jobs Act of 2017 in late December. The act lowered the marginal corporate federal tax rate to 21%. All of a sudden, things just aren’t the same anymore.
What Has Changed?
At first blush, the impact of the recent tax cut is straightforward. Lower taxes mean higher after-tax cash flows, which should translate into higher values for businesses. But how much higher? Value is a function of expected cash flows, expected risk, and expected growth. While expected cash flow (after-tax) will be rising following the corporate tax cut, what happens to expected risk and expected growth?
The stock market anticipated the tax cut during 2017, and stocks began to rise. There was a period of uncertainty during the third quarter of 2017, but the overall rise continued through the passing of the tax act. The chart below shows three indices, the S&P 500, the NASDAQ, and the Russell 2000. All three indices rose 20% or more through early January 2018. Then, there was a sharp sell-off. Does anything go up forever?
Following the sell-off, stock prices seem to be on the rise again as we proceed into March 2018.
While we cannot pinpoint all of the stock price increases since the beginning of 2017 to the tax cut, it is generally accepted that lower corporate taxes are the engine fueling stock price growth over the last year.
Business appraisers can think about the corporate tax cut, but the reality of addressing its impact on business values is beginning to hit home with the large number of year-end (December 31, 2018) appraisals for tax planning, buy-sell agreements, ESOPs and other reasons. Business appraisers will have to value thousands of companies as of December 31, 2018, a date that is after the passing of the Tax Cut and Jobs Act of 2017. We don’t have to speculate about whether the tax cut will happen or not.
A recent analysis at Mercer Capital indicates that public market forward EBITDA multiples have expanded consistent with the expectation of lower corporate taxes.
For substantial companies that will be valued by reference to the public markets (i.e., using what are called guideline public companies), the market’s expectations can be assumed to be baked into pricing. The multiples from publicly traded guideline companies reflect market expectations related to increased cash flow from lower corporate taxes, as well as the myriad of factors that influence stock prices.
Higher EBITDA multiples make sense. The tax reduction does not impact pre-tax measures of income like EBITDA, so EBITDA multiples logically have to expand in order to match the increase in market capitalizations of American companies.
I don’t have a figure, but early evidence suggests that EBITDA multiples in private company transactions have also increased in anticipation and the early months following the tax cut.
In many ways, things just aren’t the same anymore.
Public and Private Company Comparisons for 12/31/17 Appraisals
If Mercer Capital’s customer base is at all representative of national private companies, the guideline public company method using direct comparisons with publicly traded companies may not be especially helpful for many valuations. Companies are either too small for realistic comparisons with larger public companies, or it is not possible to develop a group of public companies that are reasonably comparable to the subject private companies appraisers will be valuing. The fact that appraisers cannot develop guideline public company groups for comparison with many private companies is not new.
The guideline transactions method, however, will likely also be of little use going forward, at least for a few years. All of the databases of private company transactions with their thousands of transaction observations took place under the previous tax law with higher corporate tax rates. The transaction multiples reflected in these historical databases do not reflect expectations of substantially higher after-tax cash flows following the 2017 tax act (except for perhaps a few during the latter part of 2017).
Importantly, the history of guideline transactions is the source of many “rules of thumb” regarding the values of private companies. Previously, I’ve written about these “rules of thumb” and we will discuss in the next post how to estimate EBITDA multiples using the Adjusted Capital Asset Pricing Model.
The point of this qualitative discussion, however, is that the old “rules of thumb” were thrown out the door when President Trump signed the Tax Cut and Jobs Act of 2017.
Things just aren’t the same anymore.
One Appraiser’s Initial Reaction to Change
A few days ago, I participated in what we at Mercer Capital call “valuation committee” for a recurring client of substantial size. We have a group of guideline public companies we use as a basis for developing valuation multiples. The market caps of the public companies are well up since the last valuation, and the public multiples of EBITDA are higher, as well. Combined with good performance, the guideline public company analysis supports a significant increase in value for this client.
When we looked at the discounted cash flow method, lower expected taxes (down from about 39% to about 25%), and increased expected debt-free cash flow relative to prior appraisals, the DCF value indication was also up substantially.
Given the change in tax law, there was a significant change in the value of a large deferred tax liability. Booking the change based on the reduction in tax rates flowed more than $50 million into equity.
Value was pouring in from all angles and the indicated valuation was up a great deal.
My first reaction with recurring clients when there is a substantial change in indicated value is to be sure that it is real and permanent. My initial reaction with this client was that value was increasing “too much.” However, when we looked the individual assumptions (the company’s sales and earnings, the normalizing adjustments, and the outlook based on projections) with a magnifying glass, they all passed muster. When we cut through it all, the primary drivers in the increased value were increased EBITDA over the previous period and the reduction in corporate tax rates. The value change is real.
Things just aren’t the same anymore.
What’s Coming Next?
In the next post, we will provide a marginal analysis of the impact of the Tax Cut and Jobs Act of 2017 on private company cash flows, valuations, and valuation multiples. This analysis is important because, you guessed it, things just aren’t the same anymore.
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