With the passage of the new tax reform last year, so many Americans are now wondering how the new regulations will affect their pocketbooks. I’ve written about the changes you may see in your paychecks and tax bills. Now I want to turn the lens to another, equally important but perhaps less obvious, issue – how the corporate tax cuts will impact you.
We all know the corporate tax rate has been reduced from 35% to 21%, but most of us may believe this piece of the reform is too removed from our day-to-day lives to have any significant impact. But remember your 401(k) depends on how well the market fares, which in turn depends on how well corporations fare.
So, this is an important subject to explore. Let’s talk through how tax reform’s corporate cuts could influence your retirement accounts.
First, let’s discuss where the earnings number lies, as it matters tremendously for long-term returns. Financial professionals like myself, as well as others in different sectors, are always interested in earnings; this number is the foundation of how markets trade and makes up the lion’s share of what drives your 401(k) returns.
Overall, analysts project 2018 to be a year that will usher in a boost in earnings. In 2017, earnings for the S&P 500 came in at about $130. For 2018, the projection for earnings without considering tax reform was $145. This expected increase is attributed to the projected continued growth of American companies.
Now that the tax reform bill is law, however, analysts’ estimates are going even higher. The consensus is that the corporate cuts could clock earnings in around $10 to $20 higher. This is big news for all investors.
Assuming we’ll hit closer to the $20 mark, that’s a move from $145 up to $165, which represents an almost 15% increase. This means that in addition to the $15 increase from last year, we could see an additional increase of $20 under the new tax bill. If we compare this estimated earnings number for this year with 2017, we see a tremendous increase – approximately 27%.
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Keep in mind that these numbers take into consideration the new corporate cuts, as well as other variables. In addition to the tax breaks, companies also got hit with an additional cost under the reform – the so-called “deemed repatriation.” Under this new provision, American companies will finally have to pay the tax bill on their $2.6 trillion of collective cash currently stashed overseas. That’s a big bill, and it’s the result of a backlog of years of profits stacked up abroad.
How will this provision impact investors?
We still have business and economic growth moving forward, which moves earnings from $130 to $145. And we still have the anticipated $20 earnings increase from tax reform, getting us up to $165. If we back out the cost of deemed repatriation (estimated to influence earnings by $10), we land at $155. Still, this represents a 19% year-over-year rise in earnings.
And, there is a strong argument to be made to simply ignore the $10 deduction for deemed repatriation tax, since it’s only a one-time payment. If we disregard this piece, what we have is the solid argument for the whole $165 in earnings this year.
As further illustration, let’s do the math and take the S&P 500 level from today, which is about 2780, and divide it by $165. Under these calculations, we are trading at 16.8 times forward earnings.
You’re right if you’re thinking, “That’s the P/E ratio.” Remember, the Price Earnings ratio (“P/E ratio) is a measure of valuation and can be expressed for stock to stock, a particular industry or the total market. And as earnings go up, what you pay for the earnings goes down per the formula.
A P/E of 16.8 isn’t exactly expensive. Typically, a P/E of 12 is on the cheaper side, while a P/E of 30 is considered expensive. This P/E is further proof of why the market has been marching forward, and will likely continue to do so. Even better, this number doesn’t count the $120 billion in tax cuts coming to us as individuals. Inevitably, individuals will spend this money, maybe even invest in a small business, and create an even more virtuous economic cycle than the one we have now.