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How does the corporate tax rate change benefit equity investors?

In one stroke, the FM reduced the corporate rates from 34.9% to 25.2%. Let’s find out how it benefits shareholders and thus you, as an investor.

On 20-Sept-2019, the Indian Finance Minister made a significant announcement. In one stroke, the FM reduced the corporate rates from 34.9% (30 % plus surcharge) to 25.2% (22% plus surcharge). Let’s find out how it benefits shareholders and thus you, as an investor.

Let us assume a particular stock has a Profit Before Tax of Rs 100 / share. On a post-tax basis, its Earnings Per Share will be Rs 65.1 (assuming a tax rate of 34.9%). If its PE Ratio was 15 x (Price / Earnings), then the stock price would be 65.1 X 15 = Rs 976.

Based on the reduced tax rates (25.2% - which is the 22% tax rates plus surcharge and cess), its EPS (Earnings Per Share) will now be Rs 74.8. Assuming the same P/E Ratio, the stock price would now be Rs 1122 (74.8 X 15). This is an increase of 14.9% over night by a simple change in tax rates.   

The Nifty was up 5.3% on 20-Sep-2019, whereas the real impact on overall value of companies by this move is closer to 14.9%. 

Why did the overall move not come about in a single day?

#1. This is just one day and many investors are still in a state of disbelief. Such re-rating will happen over time and investors will actually watch out for any fine print emerging once the dust settles in.

# 2. Markets have been correcting over the past few months, as there are increased fears of an economic weakness. While this move may be considered to be a land mark reform, it may or may not lead to an actual economic recovery.

Based on the reduced tax rates (25.2% - which is the 22% tax rates plus surcharge and cess), its EPS (Earnings Per Share) will now be Rs 74.8. Assuming the same P/E Ratio, the stock price would now be Rs 1122 (74.8 X 15). This is an increase of 14.9% over night by a simple change in tax rates.   

#3. The gains made in tax may get competed away through lower prices to the end consumers, with the profit growth being not as high as the above equation suggests. (On the other hand, this will lead to a higher growth). Some of the gains will definitely get competed away, but not all. 

#4. Not all companies are in the highest tax bracket and the average company’s tax rates is closer to the 26-28% rate (instead of the 34.9%), partly due to various tax exemptions companies enjoy. 

On the whole, this move by the government is positive for investors in the Indian equity markets. This leads to more profits in the hands of shareholders and therefore higher value for the same company. 

As an investor, it should be a good time to invest in equities as markets have been weak since Jan 2018 and the recent tax cuts should increase overall value of listed companies and lead to better growth rates. 

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