The Business Valuation Tax Act of 2017 (Tax Act) has introduced changes to the financial and regulatory landscape that specifically affect business valuation in the context of C-Corporations. This article provides a general overview of commonly used valuation methodologies and highlights a few key effects of the Tax Act on the implementation of those methodologies.
Generally, the most common methodologies used in business valuation are the Income Approach and the Market Approach.
This approach calculates the present value of those cash flows, discounted to reflect both time value of money and uncertainty associated with the expected rate of return generated by the subject company. For these expected cash flows to the firm, a Weighted Average Cost of Capital (WACC) is a commonly-used measure of discount rate for deriving their present value. A WACC considers two basic components: Cost of Equity and Cost of Debt.
Regardless of the approach selected, it is imperative that the valuation professional exercises logical and defensible reasoning as to the relevancy of each approach and the reliability of various financial inputs in performing the valuation.
The Guideline Publicly Traded Company method identifies observed market multiples, such as Enterprise Value (EV)/Revenue and EV/Earnings Before Interest, Taxes, Depreciation, & Amortization, (“EBITDA”), or EV/Earnings before Interest, and Taxes (“EBIT”), of comparable companies similar to a subject company, and applies selected multiples to subject company financials to derive an estimate of value. Generally, the practitioner will identify comparable companies based on industry, type, size, geography, products, sales composition, etc.
The Guideline Merged & Acquired Company method uses multiples, similar to those described above, observed in previously executed transactions to derive a value for a subject company. Much like the Guideline Public Company method, the practitioner will look for comparable transactions based on industry, type, size, geography, products, sales composition, etc.
Rob Zunich, director at Barnes Wendling CPAs, says, “To understand the value of a company, it’s important to have an experienced expert complete the process”. A practitioner may use one or any combination of these approaches to derive a reasonable valuation of the subject company. Regardless of the approach selected, it is imperative that the valuation professional exercises logical and defensible reasoning as to the relevancy of each approach and the reliability of various financial inputs in performing the valuation. When executing a valuation whose timeframe straddles the old and new tax systems, care must be taken to ensure comparability.
Two important effects on business valuation of the Tax Act are a reduction to the federal corporate tax rate and a limitation on the deductibility of interest expense. While other changes such as capital expenditure deductions, acceleration of depreciation and cash repatriation should be considered, this article focuses on the direct impact of changes in tax rate and interest deductions.
In general, the Business Valuation Tax Act of 2017 lowers the federal corporate tax rate from 35% to 21%. All other things being equal, for every dollar of revenue the subject company generates, a larger portion of that dollar drops to the net income. A lower tax rate produces greater cash flows as less cash is paid to the government and more cash is retained by the business. The subject company can use this increase in cash flows to fund further investment or distribute cash flow to investors.
The limitation of the deductibility of interest expense when computing taxes potentially reduces the use of debt as a “tax shield.”
Prior to Jan. 1, 2018, firms were allowed to deduct the full amount of interest expense and take advantage of this “tax shield”. Under the new tax plan, firms will only be able to deduct up to 30% of EBITDA for 2018-2021, then 30% of EBIT following 2021. This has the greatest impact on firms that utilize high levels of leverage to generate greater returns for equity investors. Industries with firms that have a significant amount of fixed assets may also be more adversely affected by this change, as a larger percentage of those earnings may be depreciation. For companies that already employ moderate leverage, there could be minimal impact.
These aspects of the Business Valuation Tax Act of 2017 uniquely affect each of the business valuation methodologies.
As discussed previously, future cash flows are the foundation of value under the Income Approach. Due to tax reform and the drop in the federal corporate tax rate, given the same operations, a company should generate more free cash flow and thus, demand a higher valuation.
While the tax rate change should generally increase cash flow for nearly all corporations, the interest deductibility change limits that maximum cash flow increase for highly levered firms relative to debt adverse companies. Historically, tax law incentivized firms to “lever up” with debt, and take advantage of the tax shield, as every dollar of interest expense meant less taxes paid to the government (assuming the company had sufficient taxable income). The Tax Act reduces this incentive going forward.
The secondary effect of the change in interest deductibility relates to the calculation of the WACC used to discount future cash flows; more specifically, the after-tax cost of debt component.
Due to the limitations of the ability to deduct interest expense, the expected tax shield from using debt is less valuable than under the previous tax laws. For firms that have interest expense greater than the mandated limitations, the deduction limit causes an increase in the WACC, which results in a lower valuation.
Additionally, the Business Valuation Tax Act of 2017 effectively raises the after-tax cost of debt. And, because of the decreased ability to deduct interest expense, the magnitude of the tax shield available is lower due to the lower federal tax rate.
Present day valuation multiples used in the Guideline Publicly Traded Company method have already started to incorporate the new tax changes. It is expected that most firms will generate higher FCF from the same EBITDA base which, holding all else equal, should lead to higher valuation multiples.
However, many factors affect multiples and we expect that valuation multiples will evolve and change even more in the future, as market participants continue to absorb the impact of this new law.
Similarly, under the Guideline Merged & Acquired Company Method, practitioners must exercise caution when using historical multiples that were observed prior to the implementation of the new tax legislation. Given the effects on valuation multiples detailed above, historical multiples may be influenced by a tax regime that is no longer in effect, which may impact comparability and should be considered when using this approach. [Editor’s Note: To read more about valuation, check out “Business Valuation: Expert Analysis Methods in Plain English”]
Valuation professionals should exercise diligence and care when comparing present-day multiples to historical observations, as there may be no reliable way to adjust historical multiples for greater comparability across time periods.
As we transition from the previous tax system to the newly enacted Business Valuation Tax Act of 2017, business valuation professionals must develop an awareness as to the differences in the market landscape and the various consequences for valuations that span both timeframes. In any case, all valuations demand sound judgment and an understanding of the specific context to ensure the practitioner derives a reasonable valuation.
Adam Ortega has over 15 years of experience in valuation services. His experience includes valuing business enterprises, equity positions, tangible assets, financial instruments, intangible assets, stock options and intellectual property. He has primarily served clients in the chemicals, consumer, entertainment, financial services, industrial products, oil & gas and telecommunications industries.
Michael is a director in Baker Tilly’s Forensic, Litigation & Valuation Services group and has more than 15 years of experience. He has participated in engagements involving valuations, mergers and acquisitions, real estate accounting, company analysis, securities fraud, contract disputes, intellectual property, business fraud, and licensing transactions. Michael has extensive experience working in matters involving…
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