"The Pulse" --#80 / Tax Cuts = Greater Valuations

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Market Update:

Tax Cuts = Greater Valuations

We wrote a ton about the implications of tax cuts in: "The Pulse" --#33.

Today, I will walk through the financial impact of tax cuts on corporate valuations using a DCF analysis. If you’re preparing for banking interviews, you MUST read below.

Given Trumps’s plans to reduce the corporate tax rate from 21% to 15%, I needed to run some math to see what happens to corporate valuations. My gut told me tax cuts would be beneficial to valuation due to stronger profitability…however, I remembered that tax cuts actually lead to an increase in WACC (our discount rate): WACC.

A greater WACC reduces the present value of cash flows and a lower tax rate increases cash flows…so which is the greater driver of corporate valuation?

To start, I lay out my assumptions:

Operating assumptions include line items that are needed to calculate net income and unlevered free cash flow.

Our exit assumptions are needed for the two exit methods: Multiples Method and Gordon Growth Method. In this case, we assumed a 10.0x exit EBITDA Multiple and 1% growth rate.

Within our WACC assumptions we detailed the different components needed to calculate WACC and arrived at a WACC of ~8.8%. This will be our discount rate within our DCF analysis.

Then, we scratched out our operating statements:

We applied our operating assumptions to spread financials over a 5-year period. By pure consequence we got the Devil’s number for year 5 net income lol.

To make my life easy, I set D&A, Capex, and change in NOWC to $0. This allowed me to effectively anchor my FCF to tax-affected EBIT. By doing this, I’d get a really clear picture about how any changes in the tax rate may affect my free cash flow.

Next, I drove the DCF:

If you don’t know how to make a DCF, it’s very simple (DCF).

1. You spread some operating metrics over your targeted period

2. You calculate a Terminal Value using the Multiples Method or Gordon Growth Method (I used both here)

3. You discount back your free cash flows and Terminal Value using WACC 

4. You sum up your discounted cash flows and terminal value to arrive at an Enterprise Value

I calculated both exit methods because I wanted to see if a change in the tax rate favored a certain method. I also purposely adjusted my exit assumptions to ensure I was working with the same base case Enterprise Value so that I could assess changes in absolute terms.

Now for the fun part.

I ran some sensitivity analysis to test what happens to valuation and WACC when the tax rate and % of debt in the capital structure is stressed.

Due to the fact that your tax shield is reduced, WACC increases with a lower tax rate. This is BAD for valuation because a greater discount rate = a lower present value for your cash flows.

On a separate note, I was initially surprised that a greater % of debt in the capital structure still yielded a lower WACC in every scenario. I guess the spread between our cost of debt and cost equity was too wide to really drive any changes.

Now, let’s see what happened to the Enterprise Value using the Multiples Metod…

Ok, but what about the Gordon Growth Method?

Wow! Tax cuts do in fact yield a greater enterprise value…despite the increase in the discount rate. Both methods show this.

The reason is because the time value of money causes DCFs to place a heavy emphasis on your FCF calculations—especially in a high margin business similar to the one shown. So, any material changes in the operating assumptions can widely swing the valuation.

The Gordon Growth Method includes extra emphasis on free cash flow as FCF is part of its calculation! ((FCF x (1+g))/(r-g)) vs. the Multiples Method which just take EBITDA into account.

Within finance, there is so much emphasis placed on the discount rate. But as you can see, other operating changes can drive even greater changes!

Say it with me: ‘May the taxes fall and my valuations hit the Moon.’

If you want the DCF, just shoot Pete an email: [email protected] 

Disclosure: Nothing written here is financial advice or should be used for investment decisions.

Comps & Precedent Transactions Analysis

Just covering the Big 3 of Valuation today.

-Comparable Companies Analysis- 📌 

Matching apples to apples. 🍎 

At its core, comps analysis involves spreading financial metrics of very similar companies to determine how they match up against one another

You're trying to value Company A: a U.S.-based cybersecurity, SAAS business with a $20bn enterprise value 💵 

To find good comps, you want to find as many SIMILAR businesses as possible (3-5) usually works. They should be similar in:

-Industry
-Business Model
-Size
-Geography

If you check those boxes, you'll spread some multiples such as EV / EBITDA, EV / Sales, and Debt / EBITDA to assess where Company A sits amongst peers

To arrive at a valuation, you'll take your median EV / EBITDA and apply it to Company A. This is your comps valuation! ✅ 

-Precedent Transactions Analysis- 📌 

Easy one and similar to comps.

Let's revert back to valuing Company A. You want to see if there were any RECENT deals that involved the acquisition of a SIMILAR business by either:

a). a strategic buyer (typical operating company--usually a competitor)
or
b). a financial sponsor (PE firm)

The deal must be recent. Think the last 2-3 years to account for current market conditions 🗓️

So, with precedent transactions you can arrive at a proxy for Company A's value by analyzing recent transactions of similar companies

At the end of the day, valuation boils down to the number someone else is willing to pay for something 💰

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“The Pulse” #80