U.S corporate tax reform is kicking in this year and lowers the marginal corporate tax rate at the federal level from 35 percent to 21 percent.
How will the reduced tax rate affect stock values? Conventional wisdom states that lower corporate taxes will be good news: each penny saved from the IRS presumably will go to shareholders. But is that really true? Investors need to be aware of several factors to gauge the impact of tax break on stock returns. Though the tax cut applies to all the companies, each company will benefit from the tax break differently.
First, how much tax they paid under the old tax system matters. Not everyone will save 14 percent. If the firm was paying at 39 percent (combining federal and state taxes), then their savings will be 14 percent in a simplified case. But if a company was paying at a much lower effective tax rate the savings will be limited.
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Take Verizon Communications (ticker: VZ) for example, it used to pay at tax rate at around 35 percent. At the new rate, in theory it could save $2.9 billion annually (based on its 2016 taxable income).
Under the old tax regime, lots of companies have an effective tax rate (tax paid/taxable income) much lower than 39 percent. For example, Johnson & Johnson ( JNJ) had an effective tax rate in 2016 of about 17 percent, even lower than the new tax relief rate. This occurs because those firms generate a significant portion of income in foreign countries where the nominal tax rate is much lower than the U.S. They keep the profit on foreign soil so that they don’t have to pay the between-country differentials. These types of companies will not benefit as much from tax savings on future income, but they will benefit from moving cash home.
The corporate tax reform lowers the cost of repatriating cash overseas from 35 percent to 15.5 percent. For example, in January, Apple ( AAPL) announced it will repatriate the $250 billion overseas cash back to the U.S. in the next five years. In doing so, Apple will pay $38 billion in repatriation tax. It sounds like a lot, but is significantly lower than under the old system.
How will the repatriated cash affect stock price? Some argue it doesn’t make a difference. One dollar in Ireland or in the U.S. is $1 on a company’s balance sheet. But understand that the value of cash is not its face value today, but the expected cash flows it can bring in. So the value of a dollar could be higher or lower than $1 depending on the expected usage and the value of cash trapped overseas is significantly discounted by stock market.
Domestic cash is more valuable to shareholders because it tends to be deployed more efficiently than cash trapped overseas. Apple used to issue bonds in the U.S. market to finance its stock buyback program to avoid repatriating tax. With domestic cash the debt issuance cost can be saved. In addition, companies can invest the cash with higher returns. Not having to limit M&A targets to in those foreign countries where their cash is trapped, they may find better targets to acquire.
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To figure out if the firm you are interested in has overseas cash, you can read through their 10K forms or their annual report. Though the disclosure is not required, more than 50 percent of Standard & Poor’s 500 index companies voluntarily disclose overseas cash amounts.
Secondly, how the cash is spent matters. A company faces a few options on the deployment of cash.
— Spend it on employee salaries and benefits.
— Spend it on capital expenditure and M&A.
— Spend it on raising dividends and share buybacks.
— Pay down debt.
Investors need to pay attention to the planned use of cash, because the value of additional cash depends on how it is deployed.
Spending it on raising dividends and share buybacks will benefit investors directly, as tax savings becomes payout to shareholders. The only scenario that payout is not good for investors is if competitors use the extra capital to acquire firms and speed up investment, while the company you invest in is giving money back. And competitors may take the opportunity to gain market share by using the money strategically.
The impact of allocating cash to capital expenditure and M&A on stock price depends on several components. In general, increasing capital expenditure is a good thing. It allows the firm to invest in new technology, to better serve the customers and to gain market share.
But there could be value-decreasing growth — corporate executives shouldn’t decide to spend for spending’s sake and rush into M&A deals. Poor acquisition decisions are especially likely when executives have a bulging wallet of cash. Under low-rates environment, many companies have access to cheap debt and together with the freed up cash from the new corporate tax bill, investors must watch out for potential deterioration of quality projects and overpayment in M&As.
[See: 8 Steps for Investing a Tax Refund.]
Paying down debt is trickier. It can strengthen a company’s balance sheet, lowering cost of borrowing and conserve debt capacity for the future. But that benefit will accrue to constrained firms with higher leverage. For a company with good credit ratings, paying down debt is not going to boost the value of the stock very much.
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How Tax Reform Affects Stock Value originally appeared on usnews.com
