How does tax rate affect P/E ratio
Hi everyone,
I can't figure out the answer to the question: "How does tax rate affect P/E ratio?" As the tax rate rate increases, I am assuming that EV and Equity Value decreases, and so does the net income. The question comes to which one decreases more: Equity Value or Net income?
higher tax rate = lower net income = lower EPS = higher P/E if the stock price stays the same.
So if EPS is 2.00 and stock is $30. P/E = 15x With a higher tax rate if all being else being equal, one year later, EPS is $1.50. Stock is still $30, P/E = 20x
Thanks for the reply. I thought the stock price should decrease as well since the equity value decreases as cash flows in the future will be lowered by the higher tax rate. So one year later, all else being equal, both the EPS and the stock price decrease but can we know which decreases more? Thanks!
Difficult to say.
Could make the case that P/E decreases because as taxes rise, so too does the benefit of leverage (via interest tax shield). As such, you should expect higher leverage ratios in high tax environments. Greater leverage entails higher risk to equity and therefore a lower multiple.
I once got this question in an interview and my interviewer said this was the answer:
First of all, if you assume only that you are only looking forward one year, then PE goes up because proportionally less is taken from price than earnings. If the tax goes from 20% to 21% - govt takes certain % of FCF, and rest goes to debt holders and then equity holders. Thus the share to equity holders goes down If I have PE 20, E/P = .05, means close approximation of cost of equity (return to get from equity). If you assume the company is a mature business (capex equal to depreciation), the cost of equity should not change. Therefore the PE does not change either as EP must be similar to cost of equity.
Essentially, the E/P is an approximation for cost of equity for a mature company, which should not change (according to him) and therefore P/E also does not change.
Unfortunately, this is one of those questions that will have a different answer depending on who is asking...
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