First, it was the holidays. Then flu season hit. Next, the weather turned snowy. With all that’s been going on recently, many Wall Street analysts have been out of pocket for the past few weeks. Now, they’re back in the office and trying to catch up.
Earnings estimates, anyone?
We have been talking about how tax reform will impact earnings. As Wall Streeters have trickled back into the office, preliminary reports have trickled down on the new tax plan’s influence.
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Just as a refresher, we care about earnings and estimates because they make up the lion’s share of what drives our 401(k)’s. The most straightforward way to think about earnings is this: earnings are the foundation of where markets trade.
Let’s look at some numbers. I’m rounding here, but this is what you need to know about earnings:
1. In 2017, the S&P 500 earned about $130.
2. Estimates for 2018 were set at $145, which represents an increase as companies continue to operate and grow. But this number didn’t include any influence from tax reform.
3. Now, 2018 estimates are rapidly rising fueled by passage of the GOP tax package.
4. With the new tax plan in place, many experts have added another $10 to their earnings estimates. We could argue that $20 is more accurate. As you can see, we are talking about significant growth here. Twenty dollars on top of $145 is an almost 15% increase. That’s not small potatoes. Compared to 2017’s earnings value, it’s a 27% increase – from $130 all the way to $165.
That extra $20 comes from lower tax rates, the new territorial tax system, and a few other variables.
But we have to remember that there is also a cost to corporations under the reform. Under the act’s “deemed repatriation” requirement companies are now required to pay tax on cash they have stashed overseas. This provision will likely result in a $10 reduction of the earnings projection. Deemed repatriation is expected to touch a collective $2.6 trillion in overseas cash held by American companies. This number is so big because it represents years of business profits that were previously exempt from taxation.
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To recap, we have forward momentum for businesses and the accompanying economic growth getting us from 2017’s $130 value up to the 2018 estimate of $145. Then we have another $20 from tax reform, putting the value at $165. If we back out the one-time cost of deemed repatriation ($10), then we’re set at $155. This represents a 19% year-over-year increase in earnings. And, realistically, we could even end up at $160 as our final number, meaning we could see even more growth and prosperity.
If we choose just to ignore the $10 deduction for deemed repatriation because it’s a one-time item, we can make a solid argument for the whole $165 in earnings.
To go a step further, let’s take the current S&P 500 level, which is about 2800, and divide this number our $165 estimate. Now, we are talking about trading at 16.9 – 17.0 times forward earnings. This isn’t exactly expensive. And here we see why our current market has been marching forward.
There’s more good news. Our outline above this doesn’t consider the $120 billion in tax cuts that are coming to American families. No doubt, we as consumers will choose to spend this money, or perhaps invest in a small business. Looking at the whole pie here, we see that the way forward seems to offer an even healthier economic cycle than we’re already enjoying.
Sound too good to be true? Let’s consider a real example of tax reform in action. Verizon last week revealed that it expects savings from tax reform will add $3.5 billion to $4.0 billion to its operating cash flow this year. That amounts to a boost in earnings by about 55 cents to 65 cents a share for the year.
Can you hear me now?