By Michael Brush, MarketWatch
KAren Bleier/AFPGetty Images
Donald Trump wants to bring the word “Christmas” back into the public lexicon, rescuing it from years of banishment by the PC crowd.
He might as well just go all the way and dress up as Santa, too, as far as investors are concerned, because he will enter office bearing lots of potentially sweet presents for them.
By far the biggest: a huge tax cut for companies. Trump wants to reduce their tax rate to 15% from 35%.
He might not get that. Any reduction may more likely put the new rate at around 20%. That’s because that is closer to the level often cited by Congressional Republican leaders, says Larry Puglia, who manages $55 billion in assets including the T. Rowe Price Blue Chip Growth Fund /zigman2/quotes/208533233/realtime TRBCX +0.41% . Puglia was busy recently hunting for companies that pay high tax rates because they stand to benefit the most from a Trump tax cut, and for good reason.
Even a reduction to 20% would bring enormous benefits to investors. To gauge how much, consider this simple rule of thumb, says Bastiat Capital founder Albert Meyer, an accounting expert whose stock selections for investors are up 123% since April 2006, compared with 68% for the benchmark S&P 500 Index /zigman2/quotes/210599714/realtime SPX -0.56% .
Theoretically, at least, the market capitalization, or value, of a company should increase by the dollar amount of tax saved multiplied by the company’s price-to-earnings ratio. This is another way of saying that as earnings increase by the amount of tax saved, either the P/E has to go down or the stock price has to go up. This won’t always be the case, of course, but it is a good rule of thumb.
As an example, Meyer cites Charles Schwab Corp. /zigman2/quotes/201281754/composite SCHW -1.60% because it pays no foreign taxes. Schwab paid $734 million in federal taxes in 2015, for an effective tax rate of 32.2%. If that fell to 20%, the company might have paid $456 million in taxes, saving $278 million. Multiply Schwab’s P/E of 25.5 by that $278 million in extra earnings and you get a $7.1 billion increase in market cap. That boosts Schwab’s capitalization to $59.1 billion from $52 billion, for a 13.6% increase in the value of the company, and presumably its stock.
Here’s another way to think about it, from Puglia at T. Rowe Price. If a company has a 40% tax rate, that means it has a 60% after-tax profit margin. If you lower the tax rate to 20%, that’s a 33% boost in earnings. (The decline of 20 percentage points divided by 60% is 33%.)
“The change would be very favorable to companies that have a high tax rate,” he says. “I don’t think people are focusing on this as much as they should.”
Bigger division of wealth?
Of course, it’s tempting to write off the Trump tax cut as yet more benefits for corporate bigwigs while the little guy gets ignored. But that’s not necessarily the case. Presumably, companies would invest much of the windfall, creating new jobs, and inventing new products and drugs.
“We are robbing ourselves when we tax these engines of wealth, jobs, innovation and progress,” says Meyer. “If [former Fed Chairman] Ben Bernanke thought it was a good idea to apply quantitative easing to engineer a wealth effect, a cut in corporate taxes is far more effective and tangible.”
Plus, if the tax cut boosts the stock market, that will reduce unfunded pension liabilities at governments across the country, potentially lowering the tax burden on individuals, says Neil Hennessy, chairman and chief investment officer of the Hennessy Funds. “If you truly want to take care of middle America, you want a lower corporate tax,” he says.
The fine print
There are a few qualifiers to this theory, though.
One is that fiscally conservative Republicans may well push hard for any cut in the corporate tax rate to be revenue neutral, because of worries about our nation’s $19 trillion in debt, which goes above $60 trillion if you include promises from Medicare and other entitlements. This suggests the elimination of corporate tax deductions to offset the lower tax rate.
“We don’t know what the tax structure will ultimately look like, but many deductions might be phased out,” says Puglia. So, theoretically, as many companies could be hurt as helped by Trump’s tax changes. That could make the whole thing a wash, in terms of how much it helps the economy.
The other problem is that while the S&P 500 could get a boost from the tax cut, it would theoretically be about 10.5%. That’s certainly nice. But it won’t solve the financial woes of Chicago or other profligate governments.
For the math geeks, here’s the logic behind my estimated 10.5% boost to the market, from a corporate tax cut to 20%.
Among S&P 500 companies, 441 of them broke out U.S. taxes paid in their most recent annual reports, according to screens run for me by S&P Global Market Intelligence. I cut out the rest of them for my calculation here, since we don’t know what they paid in domestic taxes.
My “S&P 441” paid $218.6 billion in U.S. taxes in 2015. I knock that down by 7% to account for state and local taxes, for an estimated federal tax paid of $203.3 billion. This number includes current year tax paid plus deferred tax. A cut in the tax rate to 20% implies a tax savings of about $87.1 billion. That’s because 20% divided by 35% times $203.3 billion suggests a new tax bill of $116.2 billion, for the roughly $87.1 billion in savings. (That’s $203.3 billion minus $116.2 billion.)
Multiply that $87.1 billion by the forward P/E of 22 for my “S&P 441” (that P/E comes from S&P Global Market Intelligence) and we get $1.9 trillion. Added to a $18.3 trillion market cap for the 441 stocks that are my subgroup of the S&P 500, and that’s a gain of about 10.5%.