In their February 15 DataTrek newsletter, Jessica Rabe and Nick Colas refer to the classic DuPont (NYSE:DWDP) model in discussing how to deal with equity valuations. They admit that “Permanent changes to the tax code shift returns higher.” We agree. They then temper their outlook by introducing the deficit issue, inflation expectations, risks of higher interest rates, and other factors. We agree with their list, but we don’t agree that those factors are a reason to reduce the classic DuPont model valuation results.
Let’s use a hypothetical. Assume for a minute that the 500 companies in the S&P 500 Index all merged and are a huge global conglomerate that has diverse businesses that are represented by the sectors of the S&P large-cap index. The company’s 2018 earnings were estimated at $140 per share before the new tax code was implemented. And the expected growth rate of those earnings for the next 10 years was 6% per year. Therefore the earnings estimate for 2019 was 1.06 times $140, which equals $148.40 per share next year.
Now along come the tax code changes. The 2018 earnings number is revised upward to $154 per share. The 6% growth rate is unchanged. Thus the new estimate for 2019 is $163.24. Readers can quickly see how this works. Start with a higher threshold, and the growth rate is applied to a larger number. Thus the future years’ earnings numbers will be higher than they would otherwise be, and the trajectory of that future growth is based on a higher compounding rate than it would otherwise be.
So how do we value the tax code change? Do we use the same multiple of earnings that we used for the original $140 but apply it to $154? Or is it higher? Or lower? We think it is higher.
Here is where the DataTrek list becomes a challenge. Of course, future paths of growth and interest rates and inflation and other factors alter the future earnings estimates. That would be the case with or without the tax code changes.
The critical question is whether the compounding of the earnings growth rate is altered so that it is lower than the effects of the changes introduced by expectations of inflation and interest rates. And we must remember that inflation is a nominal item, so that stated earnings (in nominal terms) can be increased by inflation. That used to be a detriment, because higher tax rates were applied to those nominal earnings. That impact too has changed, since the baseline corporate tax rate has declined from 35% to 21%.
So a second item in the calculus is the reduction of the inflation tax premium. DataTrek mentions real returns in general terms. We agree. But we think that too needs more elaboration.
Note that we won’t see earnings reported for Q1 of 2018 until April. But all we have seen for 2017 revealed a very positive picture. Credit Suisse (SIX:CSGN) stated (February 16) that 85.9% of the S&P 500 market cap had reported earnings for Q4 of last year. They note a “beat rate” of 4.9%, with 73% of companies surpassing bottom-line estimates. They remind us that this compares with 4.7% and 68% over the past three years.
In sum, the earnings reports of the S&P 500 were pointing to an improving trend before the tax code change. Add in the new tax code, and it only gets better.
Note that we haven’t mentioned the repatriation effects. They are coming. Cisco Systems Inc (NASDAQ:CSCO), for example, has announced its intention to repatriate $67 billion and to use $44 billion of that for share repurchases and dividends. Clearly, Cisco’s earnings per share are positively impacted, as is its stock price. For details see
https://www.nytimes.com/2018/02/14/business/cisco-repatriation-tax-law.html. Dan Clifton of Strategas adds this observation on February 20, 2018: “We also note that Cisco’s repatriation in 2018 will be nearly as large as the combined tax cuts for all US companies in 2018 - just one company’s repatriation.”
The stock market correction took US stock prices down to levels below those that preceded the tax code passage. In fact those levels were even lower than the prices that preceded the expectations that the new tax code change would be passed. The average stock corrected about 14%. We think that was way overdone. It created an entry opportunity, and we became fully invested in our US and US Core ETF accounts. We remain that way today.
We still expect an S&P 500 Index above 3000 by decade’s end, and we still believe the disaggregation of the classic DuPont model has merit today, given the permanent nature of the tax code changes.