The Impact of Tax Reform On Stock Prices
As the debate over tax reform heats up, some firms (including Morningstar) are incorporating a lower tax rate into their pricing assumptions.
Last week, we got our first look at the framework of what potential tax reform could look like. It comes after President Donald Trump had urged Congress to start making progress on tax reform. He said now's the time to "simplify the tax code, reduce taxes very substantially on the middle class. And make our business tax more globally competitive."
Whether the administration can pass a substantial tax plan is, of course, still an open question. With promises of healthcare reform not yet coming to fruition and other issues distracting the administration from passing its agenda, no one can be certain that tax reform will happen or exactly what it will look like.
That uncertainty hasn't stopped some firms from factoring a tax cut into their models. Morningstar, for instance, is incorporating a 25% U.S. corporate tax rate in its valuation assumptions.
"Tax reform is more likely than not to happen," says Joshua Aguilar, a Morningstar equity analyst. "We made a decision to factor that into our models."
Tax Reform Light
Morningstar decided to incorporate tax reform into its calculations because, says Aguilar, if something might impact valuations, it should be accounted for.
When coming up with its tax reform estimate, Morningstar decided to split the difference. While it's still unclear what kind of reforms will be adopted, if something does pass, Aguilar thinks it will be "tax reform light." Morningstar expects the U.S. corporate tax rate will likely fall to 25% (not the 20% in the framework), there will be 10% tax on overseas cash brought back into the country, a number of tax credits will be eliminated, and there will be no border adjustment tax.
"It won't be a fundamental rewrite of the code," he says.
Neil Dwane, Allianz Global Investors' global strategist, agrees that tax reform will likely be more modest than originally planned. He thinks the corporate tax rate could fall to between 22% and 25%. Like Morningstar, Allianz thinks other tax credits will be eliminated or paired back, including the deductibility of interest.
"It won't be a straight tax cut," he says. "They're going to take some other things off the table to pay for the lower headline rate."
One of the reasons why Morningstar is taking reform into account is because any change will impact its analysts' discounted cash flow models, says Aguilar. Essentially, if a company paying a 35% tax rate now pays 25% instead, its cash flows increase.
"We're a fundamental discounted cash flow shop, so we take a company's cash flow and discount it at some present rate," says Aguilar. "That's how we come to the fair value estimate of the company."
Other research firms, however, haven't done the same, which means investors should pay attention to how valuations are being calculated when doing their research.
"Someone may factor it in and be absolutely right," says Mike Liss, comanager of American Century Value (TWADX), which earns a Silver rating from Morningstar. "It's hard for me to do. Is it going to be 35%, 25% or 15%? I have no idea."
Not Everyone Will Benefit
While investors may think that all companies will benefit from tax reform, the reality is that only a subset of listed operations will be positively impacted. Dwane says S&P 500 companies pay, on average, a 22% tax rate. If the administration does slash the corporate tax rate to 15%, that would be a boon to most operations. But if it takes a more middle-of-the-road approach, then a lot of companies may see no difference, says Dwane.
Some businesses could even lose out. Johnson & Johnson (JNJ), for instance, pays an 11% tax rate, he says. If the government takes away certain tax credits, it, and other low rate paying companies, could end up forking over more to Uncle Sam.
"Anything that doesn't significantly close the gap between tax rates, but changes the allowances people receive, could mean that some companies lose with a lower tax rate," he says.
As well, since tax changes will likely be more modest, investors hoping to get some post-tax reform bump could be disappointed. Dwane says at least some changes are already priced into the market, and with company earnings up overall this year, the lift from a tax cut may not be as great as some people expect.
"We're not convinced that we'll see a one-off re-rating of the U.S. market on the back of this," he says. "As well, the tax reform doesn't feel strategic; it feels more tactical and political with the midterm elections around the corner."
Still, several companies will benefit, and the ones that do should see earnings rise as their tax rates fall. That should cause multiples to expand, says Liss. Depending on the company, he would expect to see price-to-earnings multiples rise by two or three times. Enterprise value-to-EBITDA should climb, too.
"The amount of free cash flow will go up materially for those who have free cash flow," he says. "Then valuations will move."
Some of Morningstar's fair value estimates did indeed climb after factoring in tax reform. The fair value estimate on T. Rowe Price (TROW), for instance, went from $77 to $88 in April. Morningstar analyst Greggory Warren noted at the time that the increase in the company's fair value was largely due to the potential tax changes. Without reform, the fair value estimate would be closer to $78.
However, there is a chance that tax reform may not happen. If that's the case, then Liss expects stocks to fall. However, people won't be able to predict when that decline will start. Why? Because it will be hard to know when the tax plan officially dies.
"It's not like one day there's a white flag that goes up from the Capitol building saying ‘we surrender on tax reform,'" says Liss. "With healthcare, it wasn't as if all the sudden healthcare stocks reverted in one day. They went lower over several weeks until people figured out what was going on."
Stocks That May Benefit
For investors who believe tax reform will happen and are willing to pick their spots, Dwane says that small- and mid-cap companies as a group stand to benefit most from a tax cut, since many big operations already enjoy lower tax rates.
When it comes to individual stocks, look at companies that have a durable competitive advantage, are in unregulated industries, and have pricing power, adds Aguilar.
Companies in more competitive fields could end up passing their tax savings onto their consumers. Wider-moat operations are more likely to reinvest those funds or pay them out as dividends, which would benefit shareholders, he says.
Investors may want to consider companies that have a lot of cash overseas, too. If these companies are forced to repatriate those dollars, they could pay some of it out in a dividend or invest it back into the business. Although investors might want to make a bet on a sector--a lot of technology and pharmaceutical companies have cash overseas, for instance--every company pays a different tax rate and will be impacted by reform in different ways. It may be better to look for specific companies then to bet on an entire industry, says Aguilar.
The question investors need to ask themselves is whether they should be factoring tax reform into their own buying decisions. Dwane says it's not the main reason to invest in U.S. equities--there are better reasons to buy American stocks--but Aguilar says it shouldn't be ignored, especially if prices on some stocks are already rising due the possibility of reform.
"In investing you always need a margin of safety, the gap between price to fair value," he says. "You don't want to run a 9000-pound truck over a bridge that only supports 10,000 pounds. You want the truck to be 6,000 pounds. That's building that margin of safety around a name."
Bryan Borzykowski is a freelance columnist for Morningstar.com. The views expressed in this article do not necessarily reflect the views of Morningstar.com.
Bryan Borzykowski does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.