by Albert Meyer
Unlike this time last year, the mood among investors is bullish. Is this optimism misdirected? As ever, there is no shortage of pundits trying to stir panic and angst to gain media attention. Nothing sells investment newsletters more swiftly than fear mongering.
On the other hand, consider the fact that energy sector earnings suffered in 2015 as crude oil prices plummeted to $30 a barrel, posting a 50% decline for the year. In addition, a stronger dollar negatively impacted the earnings of multinationals. In 2016, a rebound in oil prices has a given a boost to the S&P 500 earnings, and this should continue into 2017.
Unemployment levels are low. The housing market continues to recover. Leading economic indicators also reflect optimism. Investors are stoked over Donald Trump’s promise to cut the corporate tax rate to 15%. We wrote about this last month.
Consider a company that earned net income of $750 million in 2015. If this company trades at a price-to-earnings (P/E) multiple of 20, it would have a market capitalization (market value) of $15 billion (20 times $750 million). At a tax rate of 35%, the company would have provided for taxes of approximately $404 million in 2015. All things being equal, if the tax rate drops to 15% in 2017, the company will report earnings of approximately $981 million (rounded), for a year-over-year increase of +31%. The market capitalization would also increase by +31%, if the P/E multiple remains at 20. Stated differently, if the company had not paid any corporate taxes in 2015, its market value would have been higher by more than $8 billion (20 times the tax expense of $404 million). The government gets $404 million and shareholders lose $8 billion – only in Washington.
As noted above, a lower corporate tax rate will greatly enhance corporate earnings. As earnings growth drives stock prices, one can understand why so many pundits are predicting a +20% gain in stock prices in 2017.
Another major event that could provide further strength to a market rally is that US corporations have not repatriated the bulk of their foreign profits earned over the years in order to avoid our punitive 35% tax rate. At the end of 2015, 303 Fortune 500 companies collectively held $2.4 trillion offshore. Donald Trump has indicated that he wants this money back in the US. To this end, he will offer corporations a tax incentive. A few curmudgeons in the media superciliously argue that it would not benefit the economy because corporations would use the money to buy back their own stock. If corporations buy back $2 trillion worth of stock, the money will find its way into the pockets of the sellers of those stocks. Will these investors use to the money to buy stocks, bonds, go on vacation, buy a new car or house, who knows? No matter what happens to the repatriated funds, it would definitely benefit the economy, and by implication, the stock market.
At the risk of getting too technical, we need to point out that a tax cut will also provide an enormous boost to a company’s net book value (shareholder equity minus liabilities) through a one-time gain following the restatement or downward adjustment of the deferred tax liability on the balance sheet. The tax code provides for the deferral of taxes for reasons that are too complicated to discuss. If a company defers taxes of, say, $100 million, it will have to provide for a deferred tax liability of $35 million ($100 million times the 35% tax rate). If the tax rate drops to 15%, the $35 million deferred tax liability would have to be adjusted downward to $15 million ($100 million times 15%). This adjustment would add $10 million to net book value and boost net income by $10 million in 2017. Think of it as a form of debt forgiveness.
Take Apple as an example. It has a deferred tax liability of $22 billion. As a rough approximation, this could lead to a downward adjustment of $12.5 billion at a tax rate of 15%. Apple has 5.336 billion shares outstanding, which means this adjustment would add $2.36 per share to net book value. As the company trades at a price-to-book value multiple of 4.85, all things being equal, it would add $11.45 to the stock price. As the stock currently trades at $116, the deferred tax liability restatement could boost the share price by close to +10%. It gets better. Apple’s deferred tax liability almost exclusively pertains to the deferral of taxes on un-repatriated foreign profits. If the tax code allows for the repatriation of these profits a tax rate of, say, 5%, and not 15%, the liability would have to be written down to $3.1 billion, for a $18.8 billion boost to net book value and a potential +15% boost to the stock price. Apple’s bottom line stands to gain anything from $12.5 billion to $18.8 billion, which equals 27% to 41% of fiscal 2016’s net income.
Not only are the profits of these engines of economic growth and job creation taxed, but if they distribute their profits as dividends, a tax on dividends accrue to shareholders. To add insult to injury, when shareholders sell their stock, the IRS slaps a tax on the gain.
These are cold calculated facts, but in Washington, everything gets politicized, which is another way of saying that it will take a hardnosed approach from the new Administration to get the tax cuts past the know-nothings in Congress. Perhaps, Trump with his considerable business experience is just the person to put an end to the notion that taxing corporations is an efficient means of raising revenues. On the contrary, it destroys wealth and does inestimable harm to the economy. Most Americans have some exposure to the stock market, if through no other means than state and municipal pension funds, as well as private pension funds. The investments owned by these funds amount to trillions of dollars. Many of these funds are struggling to match their assets with their underlying pension benefit obligations. A corporate tax cut would most certainly relieve these funds of any pension deficits and place them on a much sounder financial footing.
A prominent Wall Street financier and ardent Democrat told a journalist, off the record, recently: “We lost. Now it’s time to make money.”