US earnings and tax rates – a temporary conundrum

You may think that cutting company tax rates in the US from 35% to 21% of their earnings would boost after-tax earnings. But not so fast – while the longer run impact of the lower taxes will clearly benefit shareholders and employees, the immediate impact of a lower tax rate can significantly reduce, rather than improve the bottom line. This is the case with a number of the very large US banks reporting or about to report their latest results.

Citibank, according to the Wall Street Journal, is about to report a large loss for the final quarter of 2017. It will be making enough of a tax charge to its earnings – as much as US$20bn – for the bank to become loss making in 2017. Some of the other major US banks, for example JPMorgan, will also be deducting large sums (in its case $2.4bn) from its earnings as a once-off adjustment for lower tax rates to come. Wells Fargo by contrast was able to add $3.35bn to its earnings, as was another large bank, PNC, which added about 9c to its reported earnings of $4.18 a share.

The banks and firms that are able to immediately boost earnings have net deferred liabilities, some $2.37bn worth in the case of PNC. In the past, these provisions against future tax liabilities had been deducted from earnings. Now with lower tax rates, this reserve can be reduced and added back to earnings. JPMorgan and Citibank, by contrast, have on balance accumulated tax assets rather than liabilities. They include tax benefits to be realised in the future as an asset on their balance sheets. The accumulation of such potential benefits has boosted earnings over the years. At a lower tax rate, these assets are worth less when they are written off against current earnings.

Incidentally, the Journal article while commenting on the generally very favourable operating performance of the bank as a whole also reports a further charge to JPMorgan earnings, as follows:

“JPMorgan’s corporate and investment banking unit was weighed down by weak trading, slumping 17% to $3.37 billion after stripping out the tax-overhaul impact. It also was hit with losses as high as $273 million related to client Steinhoff International Holdings NV, which is dealing with a wide-ranging accounting probe that is expected to also dig into other large banks’ results.” (WSJ, Peter Rudegeair)

These important recent developments on the earnings front raise the issue about the usefulness for investors or operating managers of these heavily and frequently adjusted bottom-line earnings. Quarterly reported earnings cannot be regarded as a reliable measure of the long run potential of the companies reporting. Nor, since the definition of earnings has changed so much over the years, can these reported earnings be helpfully compared to earnings in the past, nor to historic share prices, in the hope that price earnings ratios will revert to some long run average.

But there is one measure of the performance of a company or of a stock market that has the same meaning and significance today that it has today as it did 50 or 100 years ago. That is the cash paid out to shareholders as dividends. Companies do not easily pay away real cash unless they are confident they can maintain such payments. As such their dividend payments constitute a very real measure of normalised earnings.

A comparison between S&P 500 Index earnings and dividends makes the point. As we show in figure 1 below, dividend flows are far smoother than earnings; smooth enough to be regarded statistically as well as for economic reasons as a normalised measure of earnings.

Of particular significance is that dividends survived the financial crisis of 2008 far better than earnings, as may be seen. Earnings in that period collapsed dramatically as all the failed loans and less valuable assets of the banks and financial institutions were written off earnings. Dividends held up relatively to earnings to reflect the future of US business rather than its immediate past.

And share prices since the crisis are much better explained by the flow of dividends than the flow of earnings. As may also be seen in figures 2 and 3, dividends payments by S&P 500 companies grew steadily between 2014 and 2016, even as earnings fell away sharply in 2014. This helped to support further improving share prices.

S&P Index dividends moreover have continued their steady advance even as earnings have rebounded very strongly, as the figure shows. Dividends since 2012, a period when the S&P Index gained an average 13% p.a., have grown on average by 10.5% p.a, while earnings grew by 3.5% p.a on average, with twice as much volatility. It would appear investors bidding up share prices were taking more notice of normalised than actual earnings, that is of the consistent growth in dividends.