Valuation is inherently forward-looking in that the present value of any investment is equal to the sum of its risk-adjusted future cash flows. Those cash flows are dependent on a number of variables such as expected revenue, profit margins, growth rates, working capital requirements, and last but not least, taxes. So that begs the question, what impact did the recent tax overhaul have on valuations?
First of all, let’s start with the premise of why we need to apply a tax rate in the first place, even if a company is a pass-through entity such as an S-Corporation. Investors care about the net future cash flows (i.e., return) they will get from their investment and any tax burden reduces the amount of cash flow available to them. Whether the company has a direct tax burden such as a C-Corporation, or a pass-through liability such as an S-Corporation, an investor takes into consideration that taxes reduce the amount of cash flow that can be distributed to them or reinvested in the business to generate larger cash flows later.
The Tax Reform Act passed in December 2017 served to reduce taxes and modify policies, credits, and deductions for individuals and businesses. Among other implications, this legislation reduced the top marginal corporate and personal federal income tax rates to 21.0% and 37.0%, respectively. Certain deductions and exemptions were eliminated, likely partially offsetting the reduction of income tax; however, overall it is expected that most corporations will pay significantly less federal income tax under HR 1. As such, lower tax rates mean more cash flow available for investors, which translates to higher valuations. Most companies we valued in 2018 saw increases of at least 10% due to Tax Reform alone, before consideration of any other business factors (e.g., changes in as expected revenue, profit margins, growth rates, working capital requirements, etc.) that impacted value.
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