The Impact of Tax Reform on the Valuation of Companies and Assets
The December passage of the Tax Reform Act of 2017 (the Act) has created an immediate impact on the calculated values of both corporations and pass-through entities.
While the long-term implications have yet to play out in terms of shifts in strategic direction, capital structure and international tax planning, one immediate result of the tax law changes is that the values of many public and private companies are increasing. While it is important to factor in the recent legislative changes, valuation professionals also must be cautious that they do not overestimate the impact of the new tax law. This article focuses on a few of the ways in which the recent legislative tax changes are having direct and indirect effects on various types of business valuations.
Effects May Vary Based on Valuation Approach
The value of a business is typically based either on a cost approach, income approach or a market approach. The effects of the tax legislation may vary depending on the approach used in the valuation. The cost approach is typically not used to value an operating business as it does not capture the going-concern nature of the entity. Therefore we will focus our discussion on the income and market approaches to value.
The income approach generally focuses on the discounted value of after tax cash flows generated by a business or asset. As such, the lower corporate tax rate, the 100% depreciation deduction for many capital expenditures through 2022 and the qualified business income deduction for certain pass-through entities are some of the changes that will generally increase the value of businesses under the income approach. A few of the changes that could offset this increase include a lower value on net operating losses (NOLs) due to the 80% annual limitation on deducting NOLs generated after 2017 and the limitation of interest deductibility. Even with the dampening impact of some of the changes, most companies using an income approach can expect to see an increase in both company and asset values in the near term.
The discount rate is another key element in the income approach and since it is primarily derived using historical inputs, it will take time to discern the true impact of the tax law changes. The tax rate itself is an input in the determination of the cost of equity and the after-tax cost of debt used in a company’s cost of capital. The limitation on the amount of interest that can be deducted annually may also impact the after-tax cost of debt for many companies that utilize debt financing. Both the lower tax rate and the interest deduction limitation will increase the cost of capital, thus dampening the impact of the lower tax rate. The mechanical effect of the tax rate changes on the cost of capital will tend to have a greater impact on those companies that have relatively high levels of debt and have little to no impact on companies that primarily use equity financing. The long-term impact of the new tax laws on market returns, interest rates and capital structure will not be known until reliable historical data emerges, but valuation professionals should consider if adjustments to current historical data is appropriate.
The market approach reflects expectations about the future and, as such, valuations using this approach have included some expectation of the tax law changes since the election of 2016. It is difficult to know how much of the market appreciation has been driven by tax changes and how much is a function of other positive market factors. Due to this inherent uncertainty, the actual passage of tax reform legislation has less of an impact than might be expected. The most common fundamentals used to value companies under the market approach are earnings before interest and taxes (EBIT), earnings before interest, taxes, depreciation and amortization (EBITDA) and revenue. None of these fundamental factors reflect the positive impact of the lower tax rate. To the extent that the values are higher, that is manifested in higher multiples, provided all other factors and circumstances remain the same. Since the impact and benefits from the recent tax reform changes will not be evenly distributed to all companies, valuations derived using a market approach must carefully consider if the comparable companies used in the analysis will derive similar benefits from the tax law changes.
The Takeaway
The broader and long-term impacts of the enacted tax reform legislation will emerge slowly over time. It is likely there will continue to be a positive effect on value, although that impact will be tempered by sunsetting provisions in the legislation itself, changes in investor expectations, shifts in international operations, changes in capital structure and other as yet unidentified factors. It is clear that for the foreseeable future, tax considerations and their related assumptions will be a critical component in every valuation. It is imperative that valuations not only reflect the obvious mechanical impacts of the tax law changes, but also consider any potential indirect effects that could enhance or offset the initial indications of increased value.
