In their February 15 DataTrek newsletter, Jessica Rabe and Nick Colas refer to the classic DuPont model in discussing how to deal with equity valuations. They admit that “Permanent changes to the tax code shift returns higher.” We agree. They then temper their outlook by introducing the deficit issue, inflation expectations, risks of higher interest rates, and other factors. We agree with their list, but we don’t agree that those factors are a reason to reduce the classic DuPont model valuation results.

Let’s use a hypothetical. Assume for a minute that the 500 companies in the S&P 500 Index all merged and are a huge global conglomerate that has diverse businesses that are represented by the sectors of the S&P large-cap index. The company’s 2018 earnings were estimated at $140 per share before the new tax code was implemented. And the expected growth rate of those earnings for the next 10 years was 6% per year. Therefore the earnings estimate for 2019 was 1.06 times $140, which equals $148.40 per share next year.

Now along come the tax code changes. The 2018 earnings number is revised upward to $154 per share. The 6% growth rate is unchanged. Thus the new estimate for 2019 is $163.24. Readers can quickly see how this works. Start with a higher threshold, and the growth rate is applied to a larger number. Thus the future years’ earnings numbers will be higher than they would otherwise be, and the trajectory of that future growth is based on a higher compounding rate than it would otherwise be.

So how do we value the tax code change? Do we use the same multiple of earnings that we used for the original $140 but apply it to $154? Or is it higher? Or lower? We think it is higher.

Here is where the DataTrek list becomes a challenge. Of course, future paths of growth and interest rates and inflation and other factors alter the future earnings estimates. That would be the case with or without the tax code changes.