The full impact of the Tax Cuts and Jobs Act will not be clear for a while, but some aspects are beginning to get some clarity, such as company valuation. In this episode of CPA Conversations, we talk to PJ Patel, co-CEO and senior managing director of Valuation Research Corporation (also known as VRC) and Anthony Pumphrey, vice president of VRC, about the developments around debt financing, bonus depreciation, and more.
By: Bill Hayes, Pennsylvania CPA Journal Managing Editor
When the Tax Cuts and Jobs Act was signed in December 2017 it emerged because of a whirlwind process that was still in great need of clarity for CPAs and tax professionals. Ten months later, while there is still a great number of questions as to how to apply the new law, some aspects of the business and accounting professions are beginning to see how the regulation will affect them long term. One such part of the business community is company valuation. To get an idea of how the Tax Cuts and Jobs Act is set to affect valuation, today we are with PJ Patel, co-CEO and senior managing director of Valuation Research Corporation, or VRC, and Anthony Pumphrey, vice president of VRC.
As we look at the Tax Cuts and Jobs Act now about 10 months or so after passage, what are some of the effects it's having on company valuation?
[Patel] Broadly speaking, what we're seeing is that values are up. Values are up probably about 15%. Although the increase in values is maybe not as high as we might have thought shortly after tax reform was passed. Part of that is due to limitations on NOLs, taxes on intangibles that are held overseas, and other items. So we're seeing an increase in value, although maybe not quite as high as we might've expected shortly after the change.
[Pumphrey] I'd also say that that's right, about 15% is the number that we've seen overall. When we look historically, the PE ratio's been around 15 times for about the last 70 years in taxes, have been in the 40% notional, 25% effective range. So, if the effective rate is reduced, that implies the PE ratio of about 17 times a day. And that's generally where the market has traded around recently. So it seems like a lot of that has been priced in. The interesting thing, we think, is that since the markets did price in the gains almost after the announcement rather than the passage of the bill, the current administration released some tax principles in early 2017, around April. And the S&P returned 13% from that date through the passage, so when PJ says 15%, again 13% of that was after the announcement prior to passage. Since then, there has been a lot of variability around that 13, little bit of upside to the 15, but there have been issues around interest deductibility and depreciation and things like that that we're still looking into.
One of the features of the tax reform is the lower corporate tax rates. What are some of the effects we're seeing of those lowered corporate tax rates in particular?
[Patel] I think the first thing that we're seeing, and this is sort of a bigger picture issue, is that we're seeing companies move back to the U.S., and IP moving back to the U.S. When you look at, there's a couple provisions within tax reform. GILTI and BEAT, they are both having an impact where companies are moving back, their intellectual property back to the U.S. We thought that we might see some other items as well, as a result of lower tax rates in terms of increased manufacturing, maybe lower debt financing. But, to date, we haven't really seen the impact of those kinds of items in the transactions that we've seen. But, overall, I think that the lower tax rate has been beneficial, but, I think the other thing we're seeing is the limitation of interest deductability. You know, although there's a lower tax rate, the impact on that is that the cost of debt has increased on an after-tax basis. So, that's one of the downsides that we've seen.
[Pumphrey] I'd say the corporate rate reductions, again, it's boosted cash flows and asset values, but it's the other provisions that had a pretty significant impact as well. You know, with the new tax regime, we have some cash being repatriated from overseas, and there are the disincentives for moving intangibles.
So, what would you say are some of the issues that are coming up in the area of debt and debt financing?
[Patel] Well, as Anthony pointed out, your after-tax cost of debt is higher today than it was before. But, to be honest with you, we're not really seeing much at this time. We expected that private equity firms, as an example, might use more equity than debt in funding transactions that they're doing, or that public companies might adjust their capital structure. But, debt is still cheap, so we're not really seeing that impact, and it's still a really efficient way to capitalize companies and transactions. We haven't really seen much of a change in the way deals are structured or the way companies are capitalized at this point.
[Pumphrey] Right, and I think that it's also that the interest doesn't really go away. It can be carried forward, so it provides a cyclical cushion, or a cushion for cyclical companies. If they can't deduct the interest this year, they can move it forward and deduct it in a year where there's a lot of profit. Again, I think in the private equity space, it's the leverage that we're seeing, still four to four and a half times even odd, a little bit less than half the capital structure. Similar trends going back to 2015 or so. And I think it's just because interest deductibility, it really doesn't have an impact until leverage hits five times from what we've seen. It really becomes a drag at that point. So as long as leverage is in four to four and a half times even though we're not seeing much of an impact in the private equity space either.
What change has occurred in limitations on net operating losses, and what are companies doing to adjust to those.
[Pumphrey] I'd say there wasn't any change we've seen to previous net operating losses. The only issue there is they just have less of a value now. It's one of those cases where reduction in taxes actually kind of hurts you on the basis where you're thinking you have this income and you can offset a pretty decent amount of your income and, all of a sudden, tax rates are lower. So, again, there's a negative there, so your DTAs are, deferred taxes, your NOLS are worth less. And, the other issue is just on a going-forward basis if it's a company that's generating new losses, the change there is that you're only able to offset, about, I think it's 80% of your taxable income now. So in the past you're able to use those NOLs, use them quick, offset as much as possible. I think companies are starting to take another look at when they can use the NOLs as well as how much.
I've seen a lot about new rules around bonus depreciation, so how are companies sort of working with those new structures?
[Pumphrey] On an ongoing basis, we've seen companies generally electing it. In the past we haven't seen companies holding off specifically on capital investment due to tax provisions. But there's the potential it could incentivize companies saying, "Okay, there's higher depreciation, bonus depreciation, now maybe we'll buy that piece of equipment right away and get the deduction." It hasn't been that apparent that that's occurring, but there's the potential that, as time goes on, it'll be more prevalent. I'd say, what's been more visible to us, just where we work in the M&A space is specifically in deals that are structured as asset sales. Because what happens there is that the fixed assets that are acquired, if they're old, if they're new, they're still treated as being deductible in a lot of cases under bonus depreciation. So, you can imagine it's not always just a capital purchase of machine or equipment, because you buy a whole company full of machines and equipment. It could have a really big impact, and I think the provisions of taking that depreciation and, you know, if you're a platform company applying that to some of your add-ons, your bolt-ons, there are different rules around this that can be definitely beneficial in the private equity space.
Is there any activity going on around the narrower restrictions on the definition of research and development expenditures and are there particular industries that are more effected by this than others? What do you think?
[Patel] We haven't seen the impact of this yet, so we haven't seen companies changing their internal programs or what they're going to be doing in terms of R&D. Although, I will say that this area is a little bit surprising to me, just given some of the provisions around GILTI and BEAT provisions within tax reform. That seemed to encourage companies to keep their high-value intangibles in the U.S. And so, with the restrictions around R&D it sort of disincentivizes R&D in the U.S., which, again, seems counterintuitive to us. In terms of the industries that this would impact, I think the easy one to think of would be in the tech space, so just given the amount of R&D that's being done in that area, any sort of restrictions around what you define as R&D could have an impact.
I will say, since it's been mentioned twice, that GILTI has to be my favorite acronym that's come out from the Tax Cuts and Jobs Act. It rolls right off the tongue.
[Patel] And I will say around that, given what we've seen over many years in terms of companies moving IP into low-tech jurisdictions, it is something that seems to be pretty well structured, I think, in terms of incentivizing companies to keep those intangible assets in the U.S. And those, oftentimes, are the ones that are driving value.
It's good to know it's both fun and practical.
But, in general, what do you think the future looks like for company valuation? Are there any aspects of the Tax Cuts and Jobs Act, or just anything else that could be coming down the pipeline that organizations think could influence it, whether it be positive or negative?
[Patel] I think, from a company perspective, tax reform has had a positive impact on value. We often think about things from an intrinsic value perspective, and I think intrinsic values have increased as a result of tax reform. Obviously, lower taxes, and therefore higher cash flow. As I spoke about just a few minutes ago, I think that the GILTI and BEAT provisions are really positive in terms of incentivizing companies to keep their IP in the U.S. So, overall, I think it is positive, politics and government spending aside, of course. Just seems to be a very positive development in terms of what we're seeing on the impact on company values.
[Pumphrey] It's definitely been positive, and individual companies have been positively impacted in general, but I'd say different provisions can impact different company values in different ways. Some provisions are more meaningful for certain firms than others, and the big five changes that we're seeing impacting valuations are just corporate rates, interest deductions, capital expenses, R&D, and the foreign income. GILTI and BEAT; just at a high level, when we think of who the primary beneficiaries were prior to tax reform, we think of a U.S. domicile company with U.S. sales. They were paying a high tax rate, they had a little bit of debt and a lot of fixed assets. Depending on where your company fits into each one of those parameters, you can kind of think about the valuation implications at a general level.