As traders and investors, it’s important that we understand how tax cuts impact the fundamental analysis we do on a company.
The Republican tax cuts are a HUGE deal folks. Understanding how tax cuts impact fundamental analysis is key to setting our 52-week price targets on stock prices.
Tax cuts make the stock market less overvalued.
Tax Cuts On Book Value
Tax cuts make a company’s book value go up. The formula for calculating book value is:
Book value = total assets – intangible assets – liabilities
Cash is an asset. As a company’s cash goes up because their tax expenses go down, the book value rises too.
Since book value represents the intrinsic net worth of a company, tax cuts make the net worth of a company rise. Normally the increase or decrease in taxes are not big enough to impact book value in a material way. However, with the biggest tax cuts in U.S. history hitting in 2018, the book value of every single company will be impacted in a positive way.
When we search for value plays, we use book value to determine if a company is underpriced or overpriced, which could indicate a potential time to buy or sell. We look for companies that trade at or below book value using the price to book ratio of less than 1. If the price to book ratio is greater than 1, then the stock is not a value play.
Republican tax cuts will have a huge impact on value stocks by way of book value.
For example, Berkshire may get a $37 billion book value boost from U.S. tax cuts. Check out this news report.
Tax Cuts on EPS
Tax cuts make a company’s EPS go up. The formula for calculating EPS is:
EPS = net income ÷ average outstanding common shares
Net income is calculated by subtracting total expenses from total revenues. If tax expenses go down, that raises net income. If net income goes up, that raises EPS.
This massive Trump tax cut will make most every company’s EPS go up. That in turn will make the entire stock market go up.
Current expectations for 2017 S&P 500 earnings indicate growth of 11.8 percent, or $131 per share. So each 1 percentage reduction in the corporate tax rate would add $1.31 to anticipated earnings.
Just to keep the math simple, let’s say most companies will get a tax cut of 10 percent. That 10 percent tax cut will boost EPS by $13.09 which translates into an earnings gain of a whopping 23 percent! Wow folks, that’s huge!
Already we are seeing a high number of S&P 500 companies issuing positive EPS guidance. FactSet reports that the Information Technology sector is on-track to have the highest number of companies issuing positive EPS guidance since FactSet began tracking EPS guidance back in 2006. Awesome! You can read the FactSet report here.
As Earnings Go Up, So Too Does Market Capitalization
As EPS increases by the amount of tax saved, either the P/E has to go down or the stock price has to go up. Therefore, the market capitalization, or value, of a company should increase by the dollar amount of tax saved multiplied by the company’s price-to-earnings ratio.
For example, say company ACME paid $10 million in taxes in 2017 for an effective tax rate of 32.2%. If that tax rate fell to 20%, the company might have paid $7 million in taxes, saving $3 million in taxes. If ACME has a P/E of 25, then if you multiple the P/E of 25 by the $3 million in extra earnings, you get a $75 million increase in market cap. If ACME had a market cap of $500 million, the new market cap would become $575 million. That would be a 15% increase in the value of the company and presumably its stock.
Crazy right? MarketWatch published an article about tax cuts impacting market cap here.
Tax Cuts on Net Profit Margin
Net profit margin is calculated from net income. Remember, net income represents the total amount of revenue left over after all expenses are accounted for. Taxes are included as an expense. Investors track net profit margin because it reflects a company’s overall ability to turn income into profit.
For example, say company ACME has revenue of $10 million for the year. The net income (or net profit) for the year is $7 million. The net profit margin for ACME would be: ($7 million ÷ $10 million) x 100 = 70%. As net income goes up from a lower tax expense, net profit margin also goes up.
I could go on with more examples of how tax cuts will positively impact the fundamental analysis metrics we use to determine if a stock is a good buy but I think I’ve covered the major ones in this article.
The bottom line is that tax cuts of this magnitude have a much bigger positive impact on fundamental analysis than most traders and investors realize.
Tax cuts make stocks less overvalued and the market has not yet priced in all the positive benefits tax cuts will reap on the U.S. economy.