It’s the End of the World As We Know It?
By Michael Stover, CPA/ABV
I am not talking about R.E.M.’s song that debuted in 1987. I am talking about the Tax Cuts and Jobs Act of 2017 (the TCJA). This recent all-encompassing piece of legislation has certainly changed the world as we know it by rewriting the tax code with sweeping reductions in tax rates for corporations and individuals and special deductions for pass-through entities. Some of these changes are permanent and some are temporary, but all will have an immediate and long-term impact on the valuations of businesses.
When asked recently if this will directly affect company valuations, I responded, “absolutely.” There’s no other option when you consider the simple valuation equation: Value = Earnings x Multiple. If taxes go down, earnings go up. If earnings go up, so does value. But like a lot of things, the relationship between the TCJA and company valuations is not that simple.
Ultimately, valuation multiples are based on the subject company’s weighted cost of capital. This is calculated by weighing the after-tax cost of debt and the cost of equity by the proportion of each in the actual or proposed capital structure of the company. The decreased tax rates have increased the after-tax cost of debt. In addition, the TCJA of 2017 limited the business interest deduction, which means that generally, a business may now not deduct interest expense for a taxable year in excess of interest income plus 30% of the business’s adjusted taxable income plus floor plan financing interest. Any excess isn’t lost but carried over to subsequent years. These upward influences upon the cost of debt will have a negative impact on valuations.
The negative impact of the reduced interest deduction, however, is generally outweighed by the decrease in tax rates, though this is not simple either. C-corporation tax rates have been reduced from a graduated scale of up to 35% to a flat rate of 21%. Pass-through entities, like S corporations and partnerships, have their income taxed directly by their owners. However, instead of providing a lower rate for pass-through business income, the Act created a new 20% deduction for Qualified Business Income.
Here, the devil is in the details concerning the definition of “qualifying” business income. Not only are there concerns regarding the limitations in how this income is calculated, but the primary concern is that this deduction, along with the reduction in personal tax rates, is only temporary. The temporary nature of these benefits has greatly reduced the pass-through entity premium over C-corporation values that we have observed in the past.
Under the market approach, public company (all C corporations) valuation multiples anticipated the effects of a tax cut before the TCJA was signed. Analyzing private company transaction multiples has suddenly become more difficult. Besides knowing how these companies are structured, we need to adjust the reported multiples if the transaction occurred before the passage of the TCJA on December 20, 2017.
While it’s not the end of the world, business valuations have certainly changed since the passage of the Tax Cuts and Jobs Act of 2017. If you are concerned about how the TCJA is impacting the value of your business, please contact Brady Ware’s Business Valuation Services team: