Will the changes in the tax code impact the value of your business?
Much has been said about the new tax law and the potential impact it has on business value. Could the recent run-up in public markets be a reflection of this new law? And how does this impact the owner of a privately-held business?
All other things being equal, the impact of reducing corporate tax rates from the old levels to ones that top out at 21% should result in an increase in business value because net cash flows will be higher. But everyone’s cash flows will be higher, right? Do all business values automatically increase by 10%? By 20%?
I think the jury is still out.
Valuation in its simplest form is summarized as an earnings stream times a multiple. We know that the earnings stream will be (should be?) higher based on lower tax rates. Therefore, the product of the two numbers will result in a higher figure.
But hold on a sec…
Investing money at its most basic level is an exercise of giving someone your money with the expectation of receiving more in the future. How much more to expect is directly related to the level of risk; the higher the risk, the higher the expected return. Government bonds are low risk with low interest rates attached while junk bonds have higher risk and higher interest rates. This is also evident in the Duff & Phelps U.S. Guide to Cost of Capital where publicly traded companies are sorted by size. The equities of the largest companies returned (as measured by appreciation and distribution) approximately 5% above risk-free returns while the smallest companies returned almost 13% more. Still with me?
Because the lower tax rates will positively impact these benchmark equity returns, the return expectations for privately held companies will rise commensurately, won’t they? What had been a good investment if the risk-adjusted cost of capital had been 15% would now be expected to return 18% (don’t hold me to these numbers—this is for example purposes only). The potential increase in valuation based on higher annual cash flows is partially offset by the increased return expectation.
You think I’m wrong. I know it. Heck, I’m not sure that I believe myself, but this is the type of thing that keeps the old gray matter working overtime. If a company has more cash flow, it can afford to service more debt or return more capital to its owners. I agree. But I believe return expectations will rise too and that can’t be ignored.