05/20/2018

Implied Market Expectations & Tax Reform

Last week, AFG hosted a quarterly conference call to review market performance in the third quarter of 2017.  For our state of the market portion of the presentation, we prepared an analysis of implied expectations in the industrial universe of the S&P500 based on current and proposed tax regimes.  In case you missed our quarterly call, AFG has prepared a write-up on this material to share with our clients.

As of 9/30/17, the US industrial equity risk premium based on AFG’s market-derived discount rate (MDDR) approach is currently 4.57%, which is a similar level to the long-term average of the US industrial equity risk premium since 1980.  Equity risk premiums reflect the nominal equity rate less the current 10-year treasury rate once we have deleveraged overall discount rates.  In general, the relationship between current market prices and forecasted cash flows reflects a consistent risk premium for equity in line with long-term risk levels.

*AFG Research: US Industrial Equity Risk Premiums, 1980 – 2017

AFG can then consolidate the S&P500 Industrial universe (which excludes Financial and Utility stocks) as a single aggregate company in the Proforma Builder, develop forecasts for the next five years before competitive advantage assumptions take over, then discount cash flows back to today based on the MDDR research used above.  Our goal was to solve for the implied market expectations as of market close on 10/10/17 using several assumptions on sales growth, EBITDA Margins, and tax reform.  Since the market has climbed nearly 20% since the election and most narratives attribute this to expectations of tax reform and deregulation, we want to start by solving for implied market expectations within a lower corporate tax rate regime, since current market prices have likely priced this in to some degree.  The three year historical median effective tax rate for this universe of stocks was 26.7%; while a new statutory corporate tax rate target is still unclear, most commentary points to the current rate of 35% falling to levels between 20 and 25% if tax reform were to occur.  Even in a lower tax rate regime, some companies with offshore headquarters or international operations will likely continue to pay lower effective rates, so we are comfortable lowering the effective tax rate in 2018 and beyond to 20%, which assumes a statutory tax rate in the mid-20s, which we believe is a conservative assumption if corporate tax reform occurs.

Current sales growth forecasts for S&P500 industrials are 6.5% in 2017 and 5.4% in 2018, and EBITDA Margins were 18.34% last year.  Assuming slightly higher sales growth over inflation at 4%/year through 2021 and EBITDA Margin expansion of 80bps to 19.14% by 2021, we can derive implied expectations that reflect the S&P500’s closing price of $2,550.64 on October 10th.  This provides a sense that current market prices seem to already reflect some degree of tax reform, as well as mildly accelerated growth and profitability sparked by potential GDP growth that tax reform would catalyze.  The matrix below provides further insight into varying market values based on incremental adjustments to sales growth and EBITDA Margins from the base case that falls in the center of the table.

*AFG Research: Implied Market Expectations, 20% Corporate Tax Rate Regime, October 10th, 2017

We can revisit this research with an additional assumption that tax reform initiatives fail, and forecast the 26.7% effective tax rate through 2021.

*AFG Research: Implied Market Expectations, Current Corporate Tax Rate Regime, October 10th, 2017

Without tax reform, it appears that the market is roughly 10% overvalued if we use the same base case assumptions for sales growth and EBITDA Margin expansion.  Without tax reform, however, a case could be made that the incremental margin expansion and growth above GDP may be harder to realize, so the impact on market prices could be even more drastic if sales forecasts fell by 1% and EBITDA Margin expectations dropped by 50bps.  This would lead to a market that is nearly 20% overvalued, effectively wiping out the gains delivered since November 2016.  Whether failed tax reform would lead to an immediate market correction or simply stalled prices over a multi-year time horizon is unclear, but it seems that the market has priced in tax reform as a near-certainty, while the recent track record of the current administration and Congress isn’t nearly as strong at delivering on initiatives.  Insiders in the current administration have a pretty strong opinion on which direction this may go, however, if tax reform fails.

Given the high-profile exposure of tax reform, we wanted to make sure our clients had a chance to review this material if they were not able to join the call.

Professional Investors Only – Request a replay of the call and slides: