As we've discussed before, it is much easier to predict a company's operating earnings than it is its net income, due to changes in debt levels, interest rates, non-operating earnings, and one-time tax items which all affect the latter but not the former. When attempting to value a company using these estimates of operating earnings, however, care must be taken to avoid blanketing each company with the same general tax rate.
Since most North American companies face a tax rate of around 35%, it is tempting to apply this estimate blindly when running a back-of-the-envelope valuation of a company under consideration. However, due to certain credits, tax treaties, and subsidiary jurisdictions, companies can have very different tax rates, which can wildly throw off a valuation.
Consider Dorel (DII.B), a diversified manufacturer of juvenile products and furniture. Because its foreign subsidiaries operate in low-tax jurisdictions, its effective tax rate is only around 15%! Dorel's 2008 income before tax was $132 million, but thanks to its low tax rate this is equivalent to income before tax of $170 million (for a company with a 35% tax rate to have the same after tax earnings as Dorel)...a massive difference!
For an even more extreme example of how a company's tax rate can affect its valuation, read what we wrote about Gildan Activewear (GIL), a company that has managed to reduce its tax rate to practically zero!
For a more detailed discussion of Dorel as a possible value investment, see this article.
Disclosure: Author has a long position in shares of DII.B
This article was written by Saj Karsan of Barel Karsan. If you enjoyed this article, please vote for it by clicking the Buzz Up! button below.
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