5 reasons new tax laws had less impact on healthcare business valuation

The below article, regarding new tax laws and their impact on healthcare business valuation, comes from Corey Palasota, a director at VMG Health.

Ever since the Tax Cuts and Jobs Act (“Tax Act”) became law on December 22, 2017, the valuation community has been trying to understand its impact on business appraisal.  At the time of passage, most valuation professionals agreed the provisions in the Tax Act would have a directionally upward impact on company value. Some experts believed the law would further fan the flames of a 10-year “bull” market in stocks; others viewed the law with more modest expectations.  Time will ultimately reveal the long-term impact of the Tax Act; however, some insights may be obtained as we conclude 2018.

As a reminder, key provisions of the law that are positive for valuation include the following:

• Lower corporate tax rate¹
• Tax depreciation advantage for small businesses²
• Tax depreciation advantage for large businesses³

Alternatively, key provisions of the law that partially offset the law’s benefits include:

• Caps on deductibility of interest expense⁴
• Changes to tax carryforward and carryback rules⁵

While most agree the Tax Act increased company value (all else equal), other dynamics seem to be at play which have muted its full benefit in 2018.  The 21.1% increase of the S&P 500 index in 2017 may be partially attributable to the anticipated Tax Act; however, it is difficult to fully ascribe these gains to the Tax Act given large uncertainty surrounding the new laws even up to its passage in late December 2017.   Since the new provisions became law, the performance of S&P 500 index has been surprisingly flat. Other dynamics the market seems to weighing include the following:

1. Uncertainty whether these lower Federal statutory rates and other reforms will be sustainable into perpetuity.  The US government continues to accrue large debt loads due to annual deficit spending.  It is unclear whether higher economic growth will offset lower government revenue due to the Tax Act.  Undoubtedly, the current government deficits are not sustainable.  Possible future scenarios include higher future taxes, higher interest rates, lower government spending or any combination thereof.  None of these scenarios are positive for valuation. Additionally, the November elections resulted in a change of control in the House in favor of the Democratic Party, who has already expressed desire to pull back some of the provisions in the Tax Act.
2. The expectation for rising interest rates is directionally negative for valuation.  The federal funds rate has increased from 0.5% in December 2015 to 2.0% as of the time of this article.  Fed Chairman Jerome Powell has expressed his commitment to another rate increase in December 2018 and the potential for three additional increases in 2019.  Rising interest rates increase borrowing costs and result in less cash flow available to equity holders which results in lower business valuations all else equal.
3. The prior effective tax rate for many corporations was already lower than the 35% statutory rate, on average; therefore, the true dollar tax savings is likely lower than the headline 14 percentage point savings (i.e. difference between the previous 35.0% statutory rate and current 21.0% statutory rate).  The average effective tax rate for all companies in the S&P 500 from 2013-2017 was approximately 24.2%.⁶
4. Companies may not be realizing the entire benefit of the tax savings due to risings costs and uncertainties.  Low unemployment rates are creating the need for higher salary and benefit levels for employees and strong demand has cause more scarcity of supplies.  While GDP is still growing, many firms are struggling to increase revenues faster than costs. Additionally, some firms are concerned about greater macro threats (e.g. trade wars, recession) and are already experiencing lower than expected earnings before taxes.  As a result, the full benefits of the tax savings may not be fully realizable to the bottom line of equity holders.
5. Transaction pricing over the last several years has been driven up, in part, due to availability and use of debt.  The new tax law seems to discourage the use of excessive debt (i.e. cap on interest rate deductibility). As a result, the effective cost of debt increases for market participants.  Pricing may be lower (directionally) to the extent the use of financial leverage is less effective to generate required equity returns to shareholders.

If anything, the introduction of the new tax laws and lack of market response in 2018 remind us business valuation is part art and part science.  Many prevailing forces ultimately influence company value and the focus on one factor, without consideration to a multitude of others, can cause misleading conclusions.  While the Tax Act is positive for valuation, the market seems to be weighting other risks. Had the Tax Act not been passed, an argument could be made the S&P 500 index would have performed worse in 2018 to date.  Tax reform may have just buffered the full impact of other headwinds.

By Corey Palasota 

Footnotes:

¹Statutory corporate federal tax rate reduced from 35.0% to 21.0%.

²Increased the amount allowable under the Section 179 Deduction to $1.0 million for 2018 on all equipment purchased and put into service between January 1, 2018 and December 31, 2018.  The maximum amount that can be spent on equipment before the Section 179 Deduction begins to be reduced was increased to $2.5 million; thereafter, the deduction available phases-out on a dollar for dollar basis up to $3.5 million.  Larger businesses that spend more than $3.5 million on equipment are not eligible for the Section 179 Deduction.

³100% accelerated bonus depreciation on qualified property, plant and equipment (which now includes purchases of used equipment) acquired and placed in service between September 28, 2017, and December 31, 2022.  Bonus depreciation is generally taken after the Section 179 Spending Cap is reached for small businesses, or for large businesses that spend over $3.5 million.  There is a gradual phase-out of the accelerated bonus depreciation beginning in 2023 through the end of 2026. 

⁴Interest expense deductions are limited for companies with average annual revenues over $25 million to 30% of EBITDA from 2018 – 2021 and 30% of EBIT thereafter. 

⁵Net operating loss (NOL) carryforwards are limited to 80% of taxable income and the ability to carryback NOLs for any NOLs generated after January 1, 2018 is eliminated (certain exceptions apply).  The carryforward period (previously indefinite) was limited to 20 years.  All pre-2018 NOLs are not subject to the 80% limitation.

⁶Based on data from S&P Capital IQ.