Since the year began just a few weeks ago the equity market has rallied over 4%, fueled by continued strong economic data, robust holiday sales, deregulation, and residual momentum stemming from the Tax Cut and Jobs Act. The tax cuts in particular warrant such a sudden move in markets.

S&P earnings will benefit by a one-time 10% increase from these tax cuts, although variations from company to company will range from no improvement at all to over 20%. These variations in tax changes still do not appear to be fully priced into companies just yet. This window of opportunity will likely close as earnings revisions and quarterly calls are released for 2018 and as the market continues to absorb the change.

 

Since the Tax Cut and Jobs Act was officially signed on December 20th, 2017 the S&P has climbed over 4%. Prior to the cut, there appeared to be limited confidence about whether any agreement would be reached. Up until about a month before the tax cuts were approved, a basket of high tax stocks had actually underperformed the market, suggesting that the bulk of the impact of the tax cut wasn’t priced in.

 

This is now changing rapidly. Stocks, especially those with the highest effective tax rates of 35%, are pricing in the benefits they will receive from the new tax code. But the changes are lumpy. Some industries that had very high tax rates, such as retail, have appropriately soared. But other companies that also had very high tax rates haven’t yet appreciated nearly as much, despite the benefit. With the passage of the new law, the corporate tax rate dropped to 21%, and for companies that were previously at the highest effective rate of 35%, earnings should increase over 21%. Many haven’t appreciated by even half of this benefit. One possible explanation for the muted response is rooted in how some analysts traditionally measure a company’s worth. A very popular way to value and compare a company’s value is known as a firm’s EV to EBITDA ratio, Enterprise Value to Earnings Before Interest, Taxes, and Depreciation and Amortization. Simply, EV to EBITDA is a measure of a firm’s value by focusing on margins and profitability (a further detailed definition is provided at the end of this text).

 

If an analyst continued to use EV to EBITDA as a valuation measure after the recent tax changes, it would completely miss the benefit from those changes since EBITDA is a measure before taxes. One would think this concept wouldn’t be lost on analysts, but I have come across several reports in the past week alone where an analyst fails to make that adjustment. One such report on Tyson Foods went through a detailed analysis about how much the company would benefit from the tax changes (over 21%), but then proceeded to conclude that the valuation of the firm didn’t change because the multiple on their EV/EBITDA ratio was in line with peers. While EBITDA doesn’t change, the amount of income these companies have after they pay taxes does change. Cash flow clearly increases. More net income remains even if gross margins and EBITDA stay exactly the same. Indeed, after this tax policy change, the average EV to EBITDA multiple in the market should climb. This misconception should dissipate over time.

 

There are additional reforms for some companies that are receiving minimal attention but will further drive earnings higher and are helping to fuel some of this market growth. This is most acute for the largest banks such as Bank of America, JP Morgan, and Wells Fargo, among others. For this group, average earnings should improve around 15% from the corporate tax change alone, about 50% better than the average S&P 500 company. However, that benefit is likely to nearly double when consideration is given for deregulation and newly approved capital return measures (due again to reduced regulation). And, none of these benefits factor in higher interest rates which have been further supported by the growth oriented fiscal policies.

 

Energy stocks are also financially benefitting from reduced regulation, although this will take more time to manifest into earnings.

 

Not all companies that had high effective tax rates will benefit from the tax change. Most utility companies, which are heavily regulated, will be required to disgorge higher profits back to ratepayers, which should extend the benefit of the tax cut to individuals. The companies themselves will not earn materially higher profits. Other firms that had lower effective tax rates due to the nature of their corporate structure, like REITs, also won’t benefit materially.

 

The market rally may be alarming to some who may fear that we’ve entered an equity bubble. But this surge was not created by low rates or easy money. Rather it is a rational and appropriate reaction driven by a change in the fundamental profitability of the market. These changes are increasingly reflected in the market, but continue to provide near term opportunities for investments.

 

 

EV = Enterprise Value. Enterprise value is the market value of common stock + market value of preferred equity + market value of debt + minority interest – cash and investments.

EV to EBITDA is a ratio of a company’s Enterprise Value divided by Earnings Before Interest, Taxes, Depreciation & Amortization.

Since the year began just a few weeks ago the equity market has rallied over 4%, fueled by continued strong economic data, robust holiday sales, deregulation, and residual momentum stemming from the Tax Cut and Jobs Act. The tax cuts in particular warrant such a sudden move in markets.

S&P earnings will benefit by a one-time 10% increase from these tax cuts, although variations from company to company will range from no improvement at all to over 20%. These variations in tax changes still do not appear to be fully priced into companies just yet. This window of opportunity will likely close as earnings revisions and quarterly calls are released for 2018 and as the market continues to absorb the change.

 

Since the Tax Cut and Jobs Act was officially signed on December 20th, 2017 the S&P has climbed over 4%. Prior to the cut, there appeared to be limited confidence about whether any agreement would be reached. Up until about a month before the tax cuts were approved, a basket of high tax stocks had actually underperformed the market, suggesting that the bulk of the impact of the tax cut wasn’t priced in.

 

This is now changing rapidly. Stocks, especially those with the highest effective tax rates of 35%, are pricing in the benefits they will receive from the new tax code. But the changes are lumpy. Some industries that had very high tax rates, such as retail, have appropriately soared. But other companies that also had very high tax rates haven’t yet appreciated nearly as much, despite the benefit. With the passage of the new law, the corporate tax rate dropped to 21%, and for companies that were previously at the highest effective rate of 35%, earnings should increase over 21%. Many haven’t appreciated by even half of this benefit. One possible explanation for the muted response is rooted in how some analysts traditionally measure a company’s worth. A very popular way to value and compare a company’s value is known as a firm’s EV to EBITDA ratio, Enterprise Value to Earnings Before Interest, Taxes, and Depreciation and Amortization. Simply, EV to EBITDA is a measure of a firm’s value by focusing on margins and profitability (a further detailed definition is provided at the end of this text).

 

If an analyst continued to use EV to EBITDA as a valuation measure after the recent tax changes, it would completely miss the benefit from those changes since EBITDA is a measure before taxes. One would think this concept wouldn’t be lost on analysts, but I have come across several reports in the past week alone where an analyst fails to make that adjustment. One such report on Tyson Foods went through a detailed analysis about how much the company would benefit from the tax changes (over 21%), but then proceeded to conclude that the valuation of the firm didn’t change because the multiple on their EV/EBITDA ratio was in line with peers. While EBITDA doesn’t change, the amount of income these companies have after they pay taxes does change. Cash flow clearly increases. More net income remains even if gross margins and EBITDA stay exactly the same. Indeed, after this tax policy change, the average EV to EBITDA multiple in the market should climb. This misconception should dissipate over time.

 

There are additional reforms for some companies that are receiving minimal attention but will further drive earnings higher and are helping to fuel some of this market growth. This is most acute for the largest banks such as Bank of America, JP Morgan, and Wells Fargo, among others. For this group, average earnings should improve around 15% from the corporate tax change alone, about 50% better than the average S&P 500 company. However, that benefit is likely to nearly double when consideration is given for deregulation and newly approved capital return measures (due again to reduced regulation). And, none of these benefits factor in higher interest rates which have been further supported by the growth oriented fiscal policies.

 

Energy stocks are also financially benefitting from reduced regulation, although this will take more time to manifest into earnings.

 

Not all companies that had high effective tax rates will benefit from the tax change. Most utility companies, which are heavily regulated, will be required to disgorge higher profits back to ratepayers, which should extend the benefit of the tax cut to individuals. The companies themselves will not earn materially higher profits. Other firms that had lower effective tax rates due to the nature of their corporate structure, like REITs, also won’t benefit materially.

 

The market rally may be alarming to some who may fear that we’ve entered an equity bubble. But this surge was not created by low rates or easy money. Rather it is a rational and appropriate reaction driven by a change in the fundamental profitability of the market. These changes are increasingly reflected in the market, but continue to provide near term opportunities for investments.

 

 

EV = Enterprise Value. Enterprise value is the market value of common stock + market value of preferred equity + market value of debt + minority interest – cash and investments.

EV to EBITDA is a ratio of a company’s Enterprise Value divided by Earnings Before Interest, Taxes, Depreciation & Amortization.

About the Author

David Lieberman

David Lieberman

Mr. Lieberman is a Partner, Managing Director, and Portfolio Manager with Advisors Capital Management, LLC (ACM), and serves on the Investment Committee. Mr. Lieberman was previously a Portfolio Manager of the Growth Strategy at ACM. Prior to joining ACM, Mr....
About the Author

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