With the election of Donald Trump as the 45th President of the United States, the stock market has rallied in what has come to be called the Trump Rally.  The rally can be seen in the following chart from Google Finance.

The Trump Rally has been fueled in part by the anticipation of cuts in corporate taxes, which was a campaign and early-presidency goal.

Stocks are up sharply in the last few months without a comparable increase in corporate earnings.  Stocks can rise in value for a number of reasons.  The Trump Rally has been fueled by anticipation of future increases in after-tax earnings resulting from lower corporate taxes.

Something is happening with the multiples of earnings placed on public shares. So what is likely to happen to multiples for successful private companies if the Trump tax cut is implemented?  Let’s take a look.

President Trump’s Initial Proposal

President Trump announced the outlines of his tax reform at the end of April 2017.  The reform calls for a reduction in the federal corporate income tax rate from 35% to 15%.

While this new corporate tax may be subject to some “negotiation” from the Great Negotiator, it is instructive to examine the potential impact the reduction might have on the valuation of private and family businesses.  For purposes of this post, assume the new federal corporate tax rate is 15%.

This analysis is preliminary and subject to change.  Most importantly, it is subject to observing the actual response of the public markets if and when the proposed lowering of corporate taxes actually occurs.

Proposed  Lower Corporate Taxes

We first examine the potential impact on earnings from a lower corporate tax rate.  Assume a private company has pre-tax earnings of $100.  For simplicity, assume that the entity is a tax pass-through entity like an S corporation or limited liability company.  The existing and proposed tax rates are:

• Existing corporate taxes.  The maximum corporate tax rate is currently 35%.  State corporate taxes average somewhere in the vicinity of 6%, and state taxes are deductible for federal income tax purposes.  So the blended effective corporate tax rate is 38.9% (35% + (1 – 35%) * 6%).  We use this blended rate below.
• Proposed new corporate taxes.  The new corporate tax rate would be 15%.  Importantly, this rate would apply to the pre-corporate tax earnings of tax-pass through entities such as S corporations and limited liability companies. Early word is that state taxes would not be deductible, so the effective corporate tax rate under the Trump proposal would be 21% (15% + 6%).  The temptation for pass-through entities to convert salary and bonus income (taxed at marginal personal rates – 35% per the proposal) into “corporate earnings” which would be taxed at 15% is for others to address.

What does this proposed lowering of corporate taxes mean in terms of prospective earnings for private corporations?  The following figure illustrates the effect of the new corporate tax rate.

Notice three things about the proposed tax cut:

• The effective blended corporate tax rate would fall 46% under the Trump proposal.  That would be a very large tax reduction
• A company with  pre-tax income of $100 would experience an increase in its after-tax income of 29.3%, rising from $61.1 to $79.0.  That is a great deal of increase in earnings and cash flow.
• Finally, the proposed tax cut has no impact on pre-tax earnings measures like pre-tax income, Earnings Before Interest and Taxes (EBIT), and Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA).

However, if the markets respond rationally to higher income and cash flow by according higher values to companies post the tax reduction, the observed pre-tax multiples will have to increase in order to reflect those higher values.

Impact on EBIT and EBITDA Valuation Multiples

If corporate earnings rise sharply under the Trump tax reform, it is logical to ask what might happen to valuation multiples, and why.  We won’t know what happens to public company multiples until things have normalized after the fact.  However, it would be good to have an estimate of the potential impact on private company multiples now.  This estimate could lead to a better understanding of the expected public market reaction.

We can estimate pro forma EBIT multiples using the Adjusted Capital Asset Pricing Model (ACAPM), described in Business Valuation: An Integrated Theory Second Edition.  We can then use a new technique from one of my recent articles to estimate the impact of the proposed changes on EBITDA multiples.

In the table below, we develop equity discount rates for a typical, reasonably successful private company under existing tax law and under the proposed changes.  Then, based on an assumption about capital structure, we develop the weighted average cost of capital (WACC) for the same company.  We use standard assumptions (highlighted in green) in the process.

• Line 7.  The equity discount rate of 16.2% is built up using what I call the Adjusted Capital Asset Pricing Model (ACAPM).  The required assumptions are highlighted in grey.  Note that there is no change to the equity discount rate under the proposed tax reform changes.
• Line 11.  On Line 8, we assumed a pre-tax cost of debt of 5.5%.  Taxes are assumed at a blended rate of 38.9% under existing tax law, with state taxes being deductible for federal tax purposes.  Taxes are assumed to be additive with no deductibility for state taxes, so the assumed tax rate is 21%, or the sum of the proposed 15% corporate rate and an assumed 6% state tax rate.  Taxes are 46% lower under the proposed structure.  That is a lot of tax savings!
• Line 12.  Note that under the proposed tax structure, there is an increase in the after tax cost of debt, which rises 29.3% because of the reduction in the tax shield with lower tax rates.
• Line 14.  On Line 13, we assumed a capital structure of 75% equity and 25% debt.  This structure is not uncommon for private companies that use debt.  Then, on Line 14, we calculate the WACC under each scenario.  WACC is 12.99% under the existing tax structure but rises to 13.24% under the proposed changes.  This increase is the result of the higher cost of debt noted just above.
• Line 16.  On Line 15, we assume a long-term growth rate of 4.0%, which is not unusual in single-period income capitalization methods.  The resulting Debt-Free Net Income Cap Rate is 8.99% under the existing tax code and 9.24% under the proposed changes.  This increase in the cap rate diminishes value a bit.  If you don’t know what these cap rates mean, or have no frame of reference for comparison, read on.
• Line 18.  We repeat the 38.9% and 21.0% tax rates on Line 17 and then use them to create Pre-Tax Debt-Free Income cap rates.  Note that Pre-Tax Debt-Free Income is precisely EBIT.  The EBIT cap rate under the existing code is 14.71%, and the corresponding cap rate under the proposed changes is 11.69%, which is 20.5% lower than under the existing tax structure.  Lower cap rates mean higher values.
• Line 19.   We see the impact on value more intuitively as we calculate implied EBIT multiples of  6.8x and 8.6x, respectively under the existing and proposed tax rates.  The EBIT multiple under the proposed tax rates would rise 25.9% based on this analysis.
• Line 21.  On Line 20, we assume an EBITDA depreciation factor of 1.20.  For a discussion of this factor, which deflates EBIT multiples into EBITDA multiples based on the historical/expected relationship between depreciation and EBIT (or EBITDA and EBIT), see here.  The linked article will suggest that the assumption of 1.20 for the EBITDA depreciation factor is within the reasonable range.  The bottom line is that, under this analysis, the EBITDA multiple would expand some 25.9%, with the multiple rising from 5.7x under the existing code to 7.1x under the proposed changes.

Will we see s significant increase in EBITDA multiples if and when the proposed corporate tax cuts are implemented?  Let’s wait and see.

Concluding Thoughts

If the tax law changes so that corporate taxes are reduced from 38.9% to 21.0%, every dollar of pre-tax income will yield more net income and more cash flow.  However, EBITDA (and EBIT) do not change, so, net of taxes, there will be more cash flow, which should be worth more.

The analysis above indicates that if the proposed changes to corporate tax rates are passed, there can be some expansion in EBITDA multiples to reflect the implied higher values.

This post is simply a first pass at looking at the potential changes that business appraisers will have to address if the proposed changes come into effect later this year or at all.

Be well,

Chris

Reminder

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