Is the Magical Earnings Growth From Lower Taxes Sustainable?
Will the real numbers please stand up?
Analyzing stocks is a tricky business in the best of times. Equity analysts and portfolio managers must decide what valuation method is the best one to use for a stock. They must decide how far out into the future to estimate earnings, what period of time they expect to hold a stock and how risky the stock might be.
The number of variables floating around when valuing a stock is dizzying.
However, most analysts use earnings estimates as a starting point. They use these numbers as a home base for screening stocks and deciding which ones are worth investing more time and effort in. Whether you are a value buyer, a momentum growth bull or a growth at a reasonable price player, you will likely begin your analysis with a consensus earnings estimate.
These are estimates that are compiled from various data feeds. FactSet, CapIQ, and Sentieo are some of the paid services that collect and distribute consensus earnings estimates. Many free sites like Yahoo Finance and Zacks include simple earnings estimates.
Depending on the stock, that consensus estimate might be the average of twenty analysts or just two. Nevertheless, these estimates matter and they tend to not stray too far from the crowd.
But the tax bill that just passed Congress is throwing a wrench into the estimate process.
You see, earnings estimates are the value of the after-tax earnings per share for each stock. For most public companies, tax rates don’t vary much from year to year. If there is a one-time event that hits the company with a much higher tax rate or a benefit that lowers it tremendously for the year, most will use an adjusted tax rate.
But the new tax code is not a one-time event that will be adjusted for. The basic assumption is that the new tax code, which grants most U.S. based companies a huge tax cut, will be in place until further notice.
My review of last quarter’s earnings results shows many companies enjoying a drop in their tax rate. The drop is as much as a 36% rate down to roughly 16%. These are HUGE drops, which deliver HUGE increases in earnings.
Think about it like this:
If a company earned $1.00 per share with a 36% tax rate but did not increase the pre-tax dollars earned by one penny, earnings per share would now equal $1.31 or thirty percent more with the lower 16% tax rate!
This is a remarkable magical feat. The question is- who will buy into it? Stock analysts by nature are trained to look at a stream of earnings over many years. A one-time rabbit out of a hat isn’t quite enough to convince me a stock is a good buy.
The big problem will arrive in 2019. The company that showed 30% earnings growth in 2018 due to a tax cut might now show no earnings growth at all. Obviously, the company may have introduced a new product or cut some expenses or made some changes to improve its operating metrics but all else staying the same, that stock is a show-me stock. It needs to prove to analysts that it can grow earnings.
This makes stock picking particularly treacherous right now. You may hear some talking heads crowing about “how cheap” stocks are. Technically that is true. However they may become cheaper, ie; drop in price, if they don’t prove that they can grow operating earnings.
I’ve always dug deeper into the estimates of the stocks I’m involved in to decipher from where the earnings growth is rising, but this year will require even more effort. I’m screening for stocks that are growing operating earnings or the old favorite EBITDA, for growth. EBITDA, that scary acronym for earnings before interest, taxes, interest, and depreciation, is a good marker for the cash earnings that a company can generate. It removes the noise of tax rates, interest payments, and non-cash charges.
It’s not perfect, but it’s a better metric than the smoke and mirrors being created by a one-time tax windfall.