The levering of EPS and EPS growth by tax cuts

[TheMotorcycleBoy]

Hi folks,

I decided to spend a little time with a spreadsheet and a simple model company, after chatting with Simon about the possibility that Mr. Trump's recent tax cutting policy could create a lasting (for the duration of the low tax regime) distortion of companies' typical EPS growth and hence PE performance indicator. For sake of posterity here is my earlier post suggesting that US tax cuts could have egged up perceptions of efficiency and here is Simon's reply.

I have set out my illustration to assume an idealised company which has no debt or significant liabilities, and each year converts 100% of it's earnings into cash. With respect to the lack of debt/liabilities, Softcat (SCT), if I recall correctly is reasonably close; however the lack of debt/liability is not necessary in this example, it merely goes to make the gearing effect more visible.

Anyway, I've additionally assumed the company has £200M as Capital to initially employ, and has a ROCE of 25% each year. Furthermore the company always retains 80% of it's profit/cash for reinvestment into it's business. Since the company has no meaningful liability all of this reinvestment has the effect of increasing the assets of productions (i.e. factories, purchasing contracts) and of sales (marketing, distribution). To keep the example clean, we can also assume that annual Capex is perfectly matched by Depreciation and Amortisation of assets.

(Out of interest we can play around with differing OM and Gross Margin rates, the distributions of costs and charges will not effect the model - which, in a zero debt, no interest, environment is effected solely by ROCE and taxation rate.)

So describing further, in the first and subsequent years the company is able to use it's capital to generate operating income in accord with it's ROCE, and after paying tax on this profits, conducting any reconciliations, use this resultant cash to pay a small dividend to it's shareholders and then use the retained 80% to further grow the sales and profits. As we can see from the table below in the first example, even with a corporation rate of 23% the company is still able to generate earnings growing at about 15.4% per year.

In the second table corporation tax was reduced to 14%, and if my model is correct, not only are the company's earnings increased so too is the compounded annual growth of those earnings to 17.2%.


Of course the above is only an idealised model, and real companies will have, presumably, the diluting effect of interest payments, exceptional settlements/costs, and probably won't be able to always convert reinvested cash into ROCE at consistent values. Furthermore some of the tax cuts may be redirected to outlets which don't directly benefit TSR [1]. However I believe it does show that in general a low tax regime can result it's companies generating consistently higher EPS growth. Presumably since many investors and market entities price according to reasonable PEG ratios (don't they?) then temporarily high EPS growth values could push up acceptable PE ratios for the effected companies.

Comments welcome,
Matt

[1] However I believe it can be illustrated in a similar way, that the same firm were it to redeploy all spare cash, not into Capital employed and growth, but into share buybacks, will skew it's EPS growth to an identical extent, due to the compounded reduction of it's number of shares.