The Great Big Huge Colossal Unknown

The Great Big Huge Massive Colossal Unknown

We have been discussing the potential of a corporate tax cut in many of our past quarterly letters. I’d like to take a look at this issue one last time by presenting some facts from a Seeking Alpha column by Bill Gunderson. Below are some extraordinary implications to the holding of technology stocks like FaceBook. 

Consider that Facebook is expected to make about $20 billion in pre-tax earnings this year on about $40 billion in sales. That works out to a whopping pre-tax profit margin of about 50%. I know that it sounds obscene, but it does not sound so obscene if you are a shareholder in the stock.

Now consider that the U.S. currently has the second highest corporate tax rate in the world. With a 39.5% (includes state and local) corporate tax rate, the only country higher than us is Japan, at a whopping 41% rate (also including state and local taxes).

That $20 billion in profit will net the Federal, State, and Local governments an approximate $8 billion in taxes. That should fill a few potholes and pay salaries. It might even buy a few fighter jets and provide a lot of food stamps for the poor and needy.

That will leave Facebook with about $12-$15 billion in after tax profits depending on how good their tax accountants are. When we divide those after-tax earnings by the amount of shares outstanding, we come up with $4.84 per share in earnings. This compares with $3.49 per share in earnings in 2016.

Facebook is looking for 39% growth in earnings this year vs. last year. Right now, the analyst’s estimates for 2018 are for $6.00 per share in after-tax earnings. This would represent another 24% increase in earnings. But remember, these numbers are not taking into account any future tax reform that could possibly come from the current Republican administration.

Now let’s begin with $6.00 per share in earnings and grow those earnings over the next five years at an average clip of 23.5% per year. My spreadsheet calculations come in at potential earnings of $14.81 per share, five years from now. I know, that is a long time from now, a lot can happen between now and then, but these are the current expectations.

At a PE ratio of 19X, the stock would be trading at about $280 per share at that time. That gives the shares just over 85% upside potential over the next five years. This is very good, but let’s take a look at what a meaningful cut in the U.S. corporate tax rate would mean for Facebook.

The number that is being thrown around right now is the lowering of the federal corporate tax rate down from 35% to 25%. If that happens, it would have a significant impact on Facebook earnings and other profitable companies. It would also have a significant impact on S&P 500 earnings.

When I go back to creating the same kind of pro forma income statements that I used as an analyst back in the early 2000’s, I come up with about a 10-17% increase in after tax earnings for a very profitable company like Facebook. The benefit becomes greater as they continue to grow and drop even greater profits to their bottom line in the future.

Those $14.81 in potential EPS five years from now, become $17.33 instead. Using that same multiple of 19X, we now have a five-year target price of $330. Remember that the original target price was $280. This represents an 18% increase in the five-year target price.