April 19, 2018
Tax Reform and Valuation Impacts to Consider
Posted by Kemp Moyer
Federal tax reform is here and there are several elements of business and asset valuation that are impacted by the recent change in legislation.
The Tax Cuts and Jobs Act of 2017 (tax reform) was signed into law on December 22, 2017, and impacts all private company business valuations performed after this date in several potentially material ways.
The change in tax rates will affect many U.S.-based businesses, and these changes, which ultimately flow through to the bottom line, will have a meaningful impact on business and intangible asset valuation, as well as the value of underlying equity securities.
Is the valuation of your company and its equity securities affected by these changes?
Simply put, any company that projects to pay U.S. taxes in the future is impacted in several ways, and this includes the enterprise value of the company, as well as its securities and certain assets. As the fair value of a company is based on the cash flow generation potential of the company on a forward-looking basis, changes in the percentage of tax cash outflows required by federal tax legislation impact the current outlook for forward retained cash flows.
These changes in tax rates will impact valuations of businesses, assets, and equity securities in several ways, including:
- Prior to tax reform, blended federal/state tax rates for entities that conducted business across the United States were estimated at approximately 39% of pre-tax income when averaging state corporate rates by population. With tax reform, this same population-weighted blended rate has been reduced to under 26%. When valuation and finance experts complete dfiscounted cash Flow (DCF) or capitalized net earnings analyses to estimate the present value of businesses or other income-generating assets, the reduction in the tax rate will generally – all else being equal – increase the present value of the estimated future cash flows. This result will be most pronounced with businesses or income-generating assets that are projected to have positive pretax income immediately or soon after the valuation date.
- In converse to the above, the value of net operating loss carryforwards (NOLs) is generally reduced in a reduced tax environment, as accumulated NOLs that will shield future pretax income will shield a lower percentage of the projected positive future earnings. Additionally, tax reform has changed the allowed usage of pre- and post-2018 NOLs. The updated laws will certainly impact values of entities that have accumulated NOLs or project operating losses prior to generating positive future operating income.
- In addition to effects on the value of NOLs, other deferred tax assets and liabilities are also impacted by the change in federal tax rates. To put it simply, companies with deferred tax assets on their balance sheets will see the value of those assets fall, whereas those with deferred tax liabilities will generally see a reduction (net positive) in the value of those liabilities.
- Also affecting DCF analyses will be the impact on the weighted average cost of capital (WACC) determined by analyzing the estimated cost of capital associated with guideline public companies (GPCs). As estimated tax rates change, this will impact the after-tax expected return on debt, as well as unlevered beta estimates. These adjustments could lead to tweaks in the expected WACC applied to subject company cash flows, affecting the estimated value.
- In market approach analyses, where observed multiples from the public markets drive applied multiples for the subject company, the impact of tax reform is not as direct, but may be similarly impactful as the fundamental value of cash flows for public companies may rise given a reduced federal tax rate. Again, all else being equal, the value of the earnings of public companies is higher with a lower tax burden. This increase in fundamental value versus a comparable higher tax environment may result in higher baseline multiples observed in the market, especially related to lines higher in the profit and loss statement, such as revenue and EBITDA.
- It should be noted that any income-generating asset, including intangible assets that are often a measurable element of transactions, may see valuations change, as these assets are commonly valued based on a DCF methodology, which will be impacted by the change in tax rates. Common identifiable intangible asset values that may be affected include: customer relationships, developed or in-process technology, tradenames/trademarks, etc. This change in fundamental value due to reduced tax rates may have a follow-on impact of changing negotiated multiples associated with transactions.
- Given the reduction in C-Corp tax rates, there may be a reduced estimated cash flow benefit to profitable business owners who elect to file under S-Corp tax status.
- Finally, as total equity values are impacted by the change in tax rates, the valuation of individual securities will also see an effect. Most notably, more junior securities such as common stock or options may see larger impact, as they are more levered to total equity value changes as compared to more senior preferred equity securities. With this leverage in play for junior securities, it is that much more important that valuation professionals properly assess the effect of tax reform at the total equity level.
The recently passed tax reform legislation is complex and the impacts may be material for the value of many businesses and their underlying securities. In this changing environment, partnering with qualified experts for business, security, and income-generating asset valuations is increasingly important to properly estimate the value of the respective assets for many needs, including IRC Section 409A analyses, ASC 805 Business Combinations, and the estimation of business or asset value for transaction analysis purposes.
As always, don’t hesitate to reach out to the Armanino team if you need assistance with business, security or asset valuation. We are happy to help our clients navigate the changes in valuation impacted by tax reform, as well as any business or asset valuation needs.
Kemp is an experienced Valuation manager at Armanino. He is a go-to problem-solving expert for CFO and Controller needs for 409A, purchase price allocation, financial due diligence, impairment testing, equity accounting. Kemp is a great resource for setting up quality processes to help growing organizations excel.