Are Valuation Experts Tax Affecting The Wrong Earnings?
Recently NYU
professor and noted valuation authority Aswath Damodaran posted a blog article (The
dividend 'tax cliff' approaches: Implications for stocks) about the potential
devaluation of dividend paying stocks if the preferred dividend tax rate were
to climb back up to the ordinary rate.
If equities would be devalued due to an increase in the dividend tax
rate, then the rate of return required by investors for equities was lower
during the period the preferential rate was in effect than before or after the
preferential rate existed. Investors
recognize the preferential tax rates available to them for long-term capital
gains and qualifying dividends, and require a lower rate of return from assets
producing tax-preferred income. This
could inspire valuation experts to make a tax adjustment reducing untaxed PTE
(Pass Through Entity) income to equate it with corporately taxed income that
qualifies for tax preference at the shareholder level. Before making this tax adjustment, the
valuation expert should consider the following:
1.
If the build-up method is used in the income
approach, and Ibbotson data is used to arrive at the discount rate, the 80+
year return averages used were derived from a period where capital gains and
dividends where predominantly not tax preferred. Non-preferred PTE earnings may be more
comparable to the historic discount rate than the recently tax preferred
corporate earnings.
2.
If a transactional data method is used in the market
approach, many of the comparable companies (depending on the size of the subject
company) will also be PTEs. Given that
the investors acquiring those companies have factored the entity status into
their decision, it would not be appropriate to convert PTE income to tax
preferred income when comparing to other PTEs.
3.
Investors offset the benefit of tax preferred
dividends against the absence of a preferential long-term capital gains tax
rate applied to C corp assets. The degree of the offset is dependent upon: the
tax circumstances of the investor, the probability of the investment being
liquidated in an asset sale, and the potential capital gains resulting from
such a sale.
While it is
clear that investors would prefer lower taxed C corp dividend income to
ordinarily taxed PTE income (all else being equal) perhaps valuation experts
are adjusting the wrong income. Instead
of reducing PTE earnings to make them equivalent to C corp earnings, then
valuing the reduced earnings using historic equity returns (which are derived
predominantly from non-tax preferred periods), perhaps the PTE earnings should
not be reduced at all. Instead, when
valuing a C corp, the required rate of return by investors should be adjusted
to factor in the relatively recent tax law preferring them. Making an adjustment to lower the required
rate of return for C corp earnings to reflect the temporary tax preference given
them would effectively increase the value of those earnings to the investor. This could be applied for the time period
that the beneficial tax rate is expected to be present. This rate adjustment could also be moderated
based the potential of an asset based sale causing capital gains to be taxed at
the corporate level. Making this adjustment would properly account for the
potential decrease in value postulated by Professor Damodaran.
