Do The Tax Cuts Justify U.S. Stock Valuations?

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by: Geoffrey Caveney
Summary

The S&P 500 median price to sales ratio is 2.60, an extraordinary all-time high valuation level compared to any previous bull market.

Some analysts believe that because the new corporate tax cuts significantly raise companies' earnings on the same amount of sales, this justifies the higher price to sales valuation.

This article analyzes the past year's numbers, the projected effect of a tax cut from 35% to 21%, and makes a projection for next year's numbers to adjust for that.

Conclusion: With the current P/S ratio, the adjusted S&P 500 median P/E ratio after the tax cuts would be 21.58, which is still a rather high valuation level.

The median "forward P/E" ratio appears much lower right now, but it would take 31.5% earnings growth across the board, on top of the tax cut gains, to justify those earnings forecast numbers.

In my recent article, "Was January 2018 The Global Stock Market Top?" I made the point that the median price to sales ratio of the S&P 500 (SPY) this year is as high as 2.63. That's an extraordinary 37% higher than it ever was at any prior stock market peak. Even at the peaks of 1999-2000 and 2007-2008, the median price to sales ratio never got as high as 2.00. (It was a big deal and a sign of bubble valuations when the market cap weighted price to sales ratio soared above 2.00 in the dot-com bubble (QQQ).)

Several readers commented that the new corporate tax cuts, which kick in on earnings made this year, are an important factor that we must take into account when we analyze valuation levels, stock prices, sales, and earnings.

Of course I agree this is an important factor, so I want to devote this article to addressing the point and analyzing the effect of the tax cuts on earnings compared to sales and stock price valuation levels.

The basic argument is that tax cuts significantly increase companies' earnings on the same volume of sales, so that justifies a higher price to sales ratio. The price to earnings (P/E) ratio is lower, reflecting a fair valuation.

Well, I want to dig deeper into the numbers to see if this is a fair conclusion or not.

As of yesterday's close, the median price to sales ratio of the S&P 500 was 2.60. The median trailing 12-month price to earnings ratio was 23.68.

"Forward Earnings" Are Guesses

By the way, let's take a moment to note that this current median P/E ratio of 23.68 is not a cheap valuation. The market has gotten so used to using "forward price to earnings" ratios, that it seems some people don't even bother to look at the actual price to earnings ratios of the last 12 months. Legendary value investors like Benjamin Graham used to laugh at and mock investors who took forward earnings forecasts seriously and used them in place of actual earnings!

"Forward earnings" are guesses. And CEOs of companies with public traded stocks have no choice but to try to satisfy the expectations of Wall Street analysts and traders who closely follow their earnings reports every quarter. Fudging the last quarter's or last year's numbers is hard, risky, and potentially illegal. But fudging the forward projection for next quarter or next year is much easier to get away with! After all, there are no legal ramifications for being wrong about that. For most companies, it's vitally important to meet or "beat the Street," matching or exceeding analysts' expectations for earnings numbers each quarter. And the easiest way to do that is to stretch the forward earnings projections in a, shall we say, optimistic direction.

For an example of what happens when a company's management is actually brutally honest about a forward projection, rather than optimistically stretching to satisfy the Street, take a look at Facebook's (FB) revenue growth projections this quarter. They decided it was time to stop playing the excessively optimistic forecast game. And their stock price was brutally punished for their honesty.

Calculating the Tax Cut Effect on Next Year's Earnings

Again, right now the S&P 500 median price to sales ratio is 2.60:

(Source: finviz.com)

And the S&P 500 median "trailing" price to earnings ratio is 23.68:

(Source: finviz.com)

Now if we divide the median price to sales number by the median price to earnings number, that gives us a median earnings to sales ratio value of 0.1098.

This is equivalent to a median after-tax profit margin of 10.98%.

Since these numbers all reflect the past 12 months, they include the last two quarters of 2017 and the first two quarters of 2018. (The large majority of S&P 500 companies already have reported Q2 2018 earnings numbers by now.) So half of these earnings were taxed at the old rate of 35%, and the other half were taxed at the new rate of 21%. This means the average effective tax rate for the past year's earnings right now is 28%.

If the median after-tax profit margin on sales was 10.98%, and the tax rate was 28%, this means the median pre-tax profit margin on sales was 15.25%. (When we start with 15.25% and take away 28% of that, the remaining amount is 10.98%.)

Now let's project that number forward, with the new 21% tax rate instead of the past year's half-and-half average 28% tax rate:

With a median pre-tax profit margin on sales of 15.25%, and a 21% tax rate, the new median after-tax profit margin on sales will be 12.05%.

This means that the median earnings to sales ratio value will be 0.1205, which is the same as the median price to sales ratio value divided by the median price to earnings ratio value.

If we take our current median price to sales ratio of 2.60, and apply the new median earnings to sales ratio value of 0.1205 based on the tax cuts, this gives us a projected forward median price to earnings ratio value of 21.58.

A median Forward P/E ratio of 21.58 is still a rather high valuation level.

But the median forward P/E ratio for the S&P 500 that you will find in the published numbers today, based on companies' latest earnings projections, appears much lower right now: 16.41.

(Source: finviz.com)

Now in order to get from the projected median P/E of 21.58, which is simply based on current numbers plus the effect of the tax cut, all the way down to a median P/E of 16.41, it would require 31.5% earnings growth across the board, ON TOP OF the effects of the corporate tax cut.

Now we can argue about the economic effects of the corporate tax cut and other policies. We can debate how much the economy will grow, how much sales growth companies will have, and how much their earnings will grow, over the next year.

But it's hard to believe that the median company in the S&P 500 will experience 31.5% earnings growth in the next year, over and above and beyond the earnings they will gain from the corporate tax cut.

But that's what the projected forward earnings forecasts and forward P/E ratio numbers are asking us to believe, if we are to take them seriously.

Seeing these numbers, I must conclude that on balance, the aggregate forward earnings projections being put forward in companies' quarterly reports right now must be wildly optimistic and unrealistic, and most companies will most likely not achieve the earnings numbers they are currently projecting. So I cannot take the present "forward P/E ratio" values seriously, in evaluating the fair current and future valuation level of the stock market today.

Therefore, I must conclude that the current valuation levels of the S&P 500, and the all-time high median price to sales ratio level around 2.60, are extremely high valuation levels indeed, even taking into account the current and future effects of the corporate tax cut on companies' earnings.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am long put options and short ETFs on select stock sectors. I am long other stocks and sectors. I am not net short the stock market.
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