Wisdom Tree, the seventh largest (by AUM) ETF provider, did a bottom up analysis of S&P companies to assess the potential earnings impact of an eventual tax reform. To summarize (their complete blog post is here):
- The effective tax rate for the S&P 500—based on the last three years of data to smooth out some noise in profitability—was approximately 27.7%, whereas the effective tax rate for small caps was almost 32%.
- We did simulations for what the new effective tax rate would be under both a 25% U.S. corporate tax rate as well as a 15% corporate tax rate that Trump has suggested wanting to implement.
- For large caps, we estimated approximately 9.1% earnings growth that comes from reducing tax rates to 25% and double that earnings growth (18.2%) with a lowering of corporate tax rates to 15%.
- For small caps, we estimated small-cap earnings growth of 11.6% with a reduction in tax rates to 25% and again double that rate to 23.1% with a reduction in corporate taxes to 15%.
Good but still incomplete assessment because there are likely to be many other tax measures that could change in the reform (e.g. interest expense, full capex deductions), not to mention the still possible BAT.
Nonetheless, let’s assume that Wisdom Tree’s numbers prove correct and that the reform is effective Jan. 1, 2017. Let’s then recalculate valuations with these new tax-reform adjusted estimates for 2017.
The S& P 500 EPS estimate goes from $131.00 to $143.96, +9.1% and the forward P/E declines from 18.1 to 16.5. The next 2 charts assume $144 in EPS.
The Rule of 20 P/E would also decline, from 22.5 to 18.8 assuming $143.96 are trailing EPS, back into undervalued territory but only 6.0% below the “20” fair value.
Note these potential caveats:
- The reform may not happen, may not happen as expected, may not happen in 2017 and may not be effective Jan. 1, 2017.
- The current 10% EPS growth rate expected in 2017 may be too high, especially with revenue growth seen at +5.3% and energy earnings seen tripling this year on the assumption that oil prices will average $60/bbl.
- The U.S. economy is off to a slower start than originally expected.
- Interest rates are rising and corporate America is heavily indebted.
Given all the above, the 6% valuation cushion appears insufficient to warrant higher risk exposure.