Zachary C. Reichenbach CFA, CPA/ABV/CFF
Principal
Ellin & Tucker
Bradford Muir
Associate
Ellin & Tucker
The Tax Cuts and Jobs Act of 2017 (TCJA), signed into law a year ago on December 22, 2017, has had several direct effects on valuations of privately owned businesses. This article will explore the TCJA’s effects on valuations of privately owned C Corporations and the ways business appraisers are modifying components of two of the common valuation methods — the income approach and the market approach — to account for these changes.
This article will specifically discuss how the TCJA changed the effective corporate tax rate, generally increasing the value of privately owned businesses. The adjustments being made to the cost of capital calculation, discount rates and changes to methods under the market approach will also be outlined.¹
Changes to the Income Approach
As highlighted in national news headlines, the TCJA permanently decreased the statutory federal corporate tax rate from 35 percent to 21 percent, a decrease of 40 percent. This results in significantly lower effective corporate tax rates, which – all else being equal – increases the valuation of privately owned businesses. Specifically, the lower effective tax rate impacts projected cash flows used in the income approach, which focuses on the income producing capability of a company. In this approach, after-tax earnings are discounted back to present value using a discounted cash flow (DCF) or an income capitalization model. In both models, the TCJA’s lower effective tax rates increase after-tax earnings, thereby generally increasing the value of privately owned businesses.
Some DCF and income capitalization models include a calculation of a company’s weighted-average cost of capital (WACC) to determine a discount rate. The WACC’s cost of debt and equity is based on the company’s existing capital structure.
The TCJA’s lower statutory tax rates cause a decrease in the federal tax deduction on the cost of debt, which increases the after-tax cost of debt in calculating the WACC. A higher after-tax cost of debt will typically result in a higher WACC. There are other TCJA changes such as the deductibility of interest expense which can alter the WACC.
Reducing the tax deduction associated with the cost of debt will ultimately increase the after-tax cost of debt. Holding all else equal, this will result in a higher WACC.2 The WACC has an inverse relationship with value meaning the higher the WACC, the lower the value and vice versa.
Overall, higher after-tax earnings discussed earlier typically offset an increase in the WACC. In other words, the TCJA generally increased the value of private businesses.
Changes to the Market Approach
There are two common methods to value privately owned companies using market multiples. The two methods derive market multiples from comparable public companies and historical transactions. Both are useful methods to value privately held companies, but each are impacted differently by the TCJA. Multiples derived from comparable public companies will likely not warrant a TCJA adjustment; however, multiples derived from historical transactions likely will require an adjustment. The reasons for this are explained below.
Market multiples that are derived from comparable public companies are based on the current stock and financial data of the comparable company on a specific date. Common data collected includes the current stock price, shares outstanding and various information from the public company’s 10-Ks and 10-Qs. Utilizing this data results in a computation of market multiples that can take many forms such as revenue multiples, discretionary earnings multiples and profitability multiples (examples: EBIT and EBITDA multiples).
That date in which this data is obtained is an important concept when using comparable public company data to derive a relative valuation for a privately owned business. This is the main reason why this method does not warrant a TCJA adjustment. A privately owned company is valued as of a certain date. That date may be as of January 15, 2018, or it could be as of April 1, 2015. There is no limitation on the date. However, whatever date is utilized for the valuation, only the known or knowable information as of the date can be utilized in the valuation. If the valuation date is January 15, 2018, then only known or knowable information as of the date can be utilized. The same concept applies for other dates such as April 1, 2015.
Under the assumption of efficient markets, any TCJA adjustments were reflected in equity prices either before the TCJA was passed (considering it was known beforehand it would pass) or shortly after December 22, 2017. Since the public company equity prices already reflect the TCJA effects for any point in time after December 22, 2017 (or shortly thereafter), no additional adjustment is necessary when using this method for a private company valuation.
If a valuation was performed for a private company in August 2017, there would no adjustment necessary either because it was not known or knowable at that point in time if the TCJA would be impacted.
A TCJA adjustment is warranted when using transaction data to derive multiples for valuing privately owned companies. The TCJA adjustment would apply when 1) the valuation date is after the date that the TCJA passed and 2) the transaction data that is being used occurred before the TCJA passed. In this instance, the transactions were based on pre-TCJA tax law with higher corporate taxes. The transactions that occurred pre-TCJA do not reflect a multiple that is based on today’s current tax structure.
The pre-TCJA transactions can be useful and derive a meaningful multiple to be applied to the privately owned business. However, they must be adjusted to reflect the differences in the tax structure between the time these transactions occurred pre-TCJA and the valuation date post-TCJA.
There is a different level of adjustment depending on whether an equity multiple or enterprise value multiple is used. An equity multiple would yield the market value of equity for the private company and an enterprise value multiple would yield the market value of the debt and equity of the private company. The TCJA adjustment for the equity and enterprise value multiple is an approximately 15 to 25 percent increase. The TCJA adjustments will vary slightly based on state tax rates and other factors. The data used in this example is based on Federal and Maryland state tax rates.4
To illustrate, let’s say a previously acquired company had an enterprise value of $120,000,000 and an equity value of $80,000,000. These values were on the date that the company was acquired prior to the TCJA. This company’s latest 12-month (LTM) EBITDA was $25,000,000 and its LTM net income was $8,100,000. The implied MVIC/EBITDA5 multiple was 6.0 and the implied MVE/Net Income6 multiple was 9.88. Based on the pre-TCJA tax structures, these will both lead to the same equity or enterprise value.
As shown in the table below, when changing the tax rate from 40 percent to 25 percent, the implied MVIC/EBITDA and MVE/Net Income multiples are no longer equal. This is due to Net Income increasing but EBITDA remaining the same.
When the implied multiples are applied to the subject company in the table above, the market value of the company’s equity changed by $20,000,000 (or 20 percent) due to the change in tax rate. The new market value of equity is now $100,000,000. To correct for this difference, a mathematical formula can be used to adjust both equity and enterprise value multiples. See the formula (Table 2).
By making this adjustment, the new tax rate will be reflected in these multiples. As a result, pre-TCJA transactions can be utilized when valuing private companies post-TCJA. Using the example of a 40 percent tax rate (old) and 25 percent tax rate (new), the adjustment to the equity multiple is 1.25 and the enterprise value multiple is 1.167. The table below shows how incorporating these adjustments make the equity and enterprise values equity based on the new tax law.
Table 1: Change in Equity and Enterprise Value between Old v New Tax Law
| Old Tax Law | New Tax Law | |
| Equity Value Adjustment Using EBITDA Multiple Approach | ||
| EBITDA | $20,000,000 | $20,000,000 |
| Pre-2018 Multiple | 6 | 6 |
| Enterprise Value | 120,000,000 | 120,000,000 |
| Less: Debt | -40,000,000 | -40,000,000 |
| Equity Value | 80,000,000 | 80,000,000 |
| Equity Value Adjustment | 1 | 1.25 |
| Adjusted Equity Value | $80,000,000 | $100,000,000 |
| Equity Value Adjustment Using Net Income Multiple Approach | ||
| Pretax Income | $13,500,000 | $13,500,000 |
| Taxes (40% old tax law, 25% new tax law) | -5,400,000 | -3,375,000 |
| Net Income | 8,100,000 | 10,125,000 |
| Pre-2018 MVE/Net Income Multiple | 9.88 | 9.88 |
| FMV of Equity | $80,000,000 | $100,000,000 |
| Enterprise Adjustment | ||
| Enterprise Value | $120,000,000 | $120,000,000 |
| Enterprise Value Adjustment | 1 | 1.167 |
| Adjusted Enterprise Value | 120,000,000 | 140,000,000 |
| Less: Debt | -40,000,000 | -40,000,000 |
| Adjusted Equity Value | $80,000,000 | $100,000,000 |
Table 2: Formula to Adjust Equity and Enterprise Value for Tax Law Change
Once the multiple adjustments are applied, we can see that the value has increased to reflect the lower effective tax rate. These adjustments enable practitioners to continue to use pre-TCJA transaction to derive market multiples for valuation purposes. Transactions from 2016 and 2017 can be useful for valuing private business in 2018, but an adjustment is required due to the TCJA. The adjustment differs by state and jurisdiction depending on the state and local tax laws.
There are a lot of nuances of the TCJA that will have an impact on the value of privately held businesses which may increase or decrease value. Holding all else equal, the decreased corporate tax rate and the adjustments to market multiples could increase value for these businesses. The effects of the TCJA are still being studied and discussed but there’s no doubt that there are changes to the way privately owned business are valued as a result.
References
- Please note that this article is not all-inclusive and will not apply to every privately owned business. There are many factors and elements that may change the results of value based on the TCJA. The information presented in this article is the outcome of various stress models and research done on the TCJA and the effects on business value holding many variables constant.
- The Cost of Equity may change as well, but we have held it constant in this example for simplicity.
- The TCJA also provides a new individual tax rate structure, and various other permanent and temporary changes to individual income tax deductions, and as a result the tax law will change the value of pass-through entities including partnerships, LLCs and S Corporations. While pass-through entities have historically benefitted from tax advantages over C Corporations, these advantages may be diminished under the TCJA for some businesses. This article is focused on the changes affecting C Corporations and will not address the TCJA and pass-through entities.
- There may be a situation where an adjustment is not warranted and should not be used. The example given is a hypothetical example in which an adjustment is required.
- Market value of invested capital (MVIC) is assumed to be the same as enterprise value and abbreviated for purposes of this article.
- MVE = market value of equity.