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Tax Rates Move Earnings

Earnings per share is all that most investors notice when a company reports quarterly results. All else equal, share prices move up when earnings substantially beat forecasts. Conversely, stocks usually drop when they fall short.

Few analysts and even fewer individual investors notice the income tax rate that was a key factor in determining earnings per share. They should. Here’s why.

Earnings per-share (EPS) is net income divided by the number of shares out. If a company had net income of $1,000 and 500 shares out, it earned $2.00 per share.

Why Tax Rates Matter
Here’s the part that most players ignore. You get net income by subtracting income taxes due from pre-tax income, which is the profit left after considering all costs except income taxes. Corporations typically pay taxes amounting to 30% to 40% of pre-tax income. But sometimes they pay a lower rate, and reported EPS skyrockets when that happens. Here’s an example.

Assume that Company A and Company B both earned $1,000 in pre-tax income, and both had 100 shares out. But they pay different income tax rates. Company A pays 20% and Company B pays 40%.

Here’s how that math works. Company A’s net income is $800 ($1000 minus $200) compared to $600 for Company B. Thus, even though they both generated the same pre-tax profit, Company A earned $8.00 per share ($800 divided by 100 shares) compared to $6.00 per share for Company B.

Tax rates always vary from year-to-year and you can see from the example, even a small change could mean the difference between whether a company beats or misses earnings expectations.

What Happens Next?
Thus, when you’re analyzing a stock, you need to know its recent income tax rate, and whether that rate is likely to move up in future quarters. Fortunately, that’s easy to do. You won’t need your calculator. You can look up the annual income tax rates going back 10 years for just about any stock on MSN Money (moneycentral.msn.com) or on Morningstar (www.morningstar.com).

When you look, you’ll see that some firms always pay lower than the typical 30%-40% rates because of conditions particular to the company or its industry. Others, however, may be enjoying a temporary tax break triggered by recent losses, or for a variety of other reasons.

Where to Get Tax Info
Both Morningstar and MSN Money display tax rates for each of the past 10 fiscal years, but Morningstar also displays the rate for the most recent reported four quarters (TTM or trailing 12-months). Consequently, I’ll describe how to use Morningstar to look up Internet auction site eBay's numbers.

Enter eBay’s ticker symbol (EBAY) in the quote box on Morningstar’s home page, and then select Key Ratios. Look for the “tax rate” figures in the Profitability section. When I looked, eBay’s most recent fiscal year (2008) and TTM rates were 18.5%, far below the 30% to 40% numbers typical of earlier years.

Not Worth Digging
Finding out why eBay’s recent tax rate is lower than usual requires some digging. Unless you get lucky with a Google search, you’ll probably have to read a recent SEC quarterly or annual report to learn the reason. In my view, it’s not worth the effort. Undoubtedly, eBay’s tax rate will eventually return to the historical norms reflected on Morningstar’s report. When that happens, eBay’s earnings growth rate will take a hit. 

In the stock market, nothing works all the time. The fact that a stock is paying unusually low corporate tax rates signals added risk. It’s no guarantee that the stock will miss its next quarter’s earnings forecast.

published 5/10/09

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