One of the more complicated and oftentimes frustrating parts of financial analysis is accounting for taxes. Changes to tax policy can have massive implications for company valuation. While some think this simply alters post-tax profit margins, it does much more than that; tax policies often influence CFOs’ plans when it comes to bond issuances, balance sheet composition, and investment directions. It’s controversial to argue that lower taxes motivate more investment in the economy—the reality is much more complicated—but changes to tax policies will almost always influence firms to change their investment strategies.
If your valuation of a company depends on earnings, book value, or debt ratios, changes to tax policies ultimately change the valuation of your model. Sometimes tax policy changes can radically impact the value of the firm you’re looking at.
So what’s an analyst to do? Many will try to account for different tax policies and make multiple models for different tax law scenarios. Others will give up and use pre-tax metrics like EBITDA and pre-tax income to create valuations. Others still will just estimate ratios based on historical trends and discount these according to their expectations for the future.
None of these approaches is perfect, but they’re all valid. And no matter what your approach, you need to keep up with corporate tax news to be aware of how your model may be changing very soon, depending on what government plans are brewing.
This is always an issue, but it has never become so vital for American investors as it has with the new Trump regime. The tax approach that President Trump has taken is a radical departure from Obama’s approach, and is different still from past republicans including George W. Bush and Ronald Regan, both of whom spent aggressively on expanding American influence without focusing on reducing spending and lowering tax burdens.
Right now, Congress is gathering to discuss how Trump’s proposed changes to the budget will influence the government’s financial health and in turn demand a different tax plan. Combine this with Trump’s plans to revamp business tax codes and you have a lot of confusion. Trump’s cabinet is expected to finalize and make public proposed tax plans in the next month or so, so there is still time for analysts to wait and see what changes are coming and how this will impact their models.
But it is something they need to be doing consistently and frequently over the next few weeks. Namely, they need to keep up on the business news and updates from the White House for any hint of a change to tax laws that will impact their models. They also need to be prepared for the market to predict those new valuations and cause fluctuations in company valuations.
When regulators change the rules, companies are often impacted directly. But the market doesn’t always recognize the severity of the impact until far, far later. This is an inefficiency that analysts can take advantage of. By careful study of all of the possible scenarios and a deep analysis of the far reaching consequences of those scenarios, analysts can provide a variety of potential valuations that they can then have on the ready when actual policy plans are released. They can then use those models to create investment strategies that will be smarter than the market as a whole. When this process is done successfully, analysts can transform insight into regulatory developments into alpha-generating, money-making investment strategies. And that is the ultimate goal of all finance.