Taxing stuff.

This discussion follows on from my previous post (EBIT +46%). From the comments that have been posted and private correspondence received, two facts have become clear to me.

1. I didn't do a very good job of making it really clear what I was talking about.
2. There is some value to be had from discussing tax a little more.

Let's quickly knock over number 1 first.

Cellestis is a young Company. You might not consider 10 years old to be young but "young" in this context means that it has only just begun it's growth and has a lot of growing to do. That alone means that any analysis of the Company performance probably puts emphasis on different characteristics than it would for a more "mature" Company.

As an aside to that it is my view that CST finds itself (from a shareholder analysis perspective) in a strange place. It is no longer a pure speculative play. A pure speculative Company usually has no income, no profits and certainly pays no dividends. All it has is potential to achieve those things. Cellestis is well and truly past that point. It has income, profits and pays dividends. On the other hand, Cellestis is not yet an "investment grade stock". Such a stock would have a number of characteristics but is probably most easily (lazily?) characterised by a PE of 15 or less. 

So, Cellestis finds itself stuck somewhere in between. At a quick glance somebody looking for a speculative play would probably not see CST as being sexy enough and somebody looking for an investment grade stock would probably see CST as having too high a PE.

Of course we know that those doing such a superficial analysis are doing themselves a disservice. That's their problem, not ours. 

Anyway, back to the theme. (did I say this would be quick?).

Because CST is "young", we who hold it as an investment are looking for something specific - growth. And we want spectacular growth. Furthermore, the growth we want is growth in earnings that come back to us, in one form or another. An effective measurement of this growth would tell us not only how fast the Company is growing but also how effectively the management of the Company is managing that growth.

During its building stage, Cellestis operated at a loss (as it should). These losses incurred tax credits. Now that the Company is making profits, they can net off those earlier tax credits against current tax payable on current profits. They have been doing this for the past few years as the profit stream has built. It seems that those tax credits have now been used up and the Company is now having to pay its full whack of tax on profits. (There may be a few tax credits remaining in overseas jurisdictions, I'm not sure). 

Okay. So, if, as I have expressed, my desire is to examine the Company growth it would make no sense to compare a figure (from last year) that has been artificially reduced by tax credits with another figure (from this year) that has not been artificially reduced. The easiest and correct way, therefore, to make that growth analysis is to drop the tax from the comparison. That is, compare EBIT (Earnings Before Interest & Tax). (It has been expressed to me that I should actually term it PBT - Profit Before Tax. That is actually correct. However it doesn't make any difference because CST has no borrowings :) and pays no Interest :) ).

Of course, as others have said, PAT (Profit After Tax) has its uses also. 

Which, conveniently segues us into a little discussion of Tax.

It is easy to say, "Well the Company sells stuff, pays for the stuff it buys and incurs some expenses along the way then pays tax to the Government - what ever is left over belongs to us and is what we should be looking at in assessing the investment that we make/hold".

Is that really true though?

As one of my friends points out - tax is not an outright (dead) expense. There is a little more to it than that.

In Australia, the Government has decided that we should not be charged twice for the earnings that we receive from the profits made by the Companies that we invest in. In the simple case (put aside overseas earnings for the moment), the Company tax rate in Australia is 30%. That means that for every $1 that our Company earns they pay the Government 30c. Leaving 70c that can be paid out to the Company owners (shareholders). Let's take the simple case of a Company that pays out 100% of post tax earnings as dividends. Dividends are counted as income for the shareholder. If we assume that the shareholder is on a tax rate of 30% then that 70c of income would attract 21c tax. That would mean that, of the $1 earned by the Company, 51c (30c + 21c) would go to the Government and the shareholder would net 49c.

Obviously that is not just and our Government agrees (not all Governments do). For that reason they have implemented a system of franking credits. 

In essence, what the Government has said is that the tax on Company earnings should be paid once and once only by the final recipient of the earnings at the tax rate of that recipient.

The mechanics of this are to firstly "gross up" your dividend to the amount of Company earnings that were made to enable them to pay that dividend (that is, add back the amount of tax that the Company paid on that dividend). In the example above that means add the 30c tax paid by the Company to the 70c dividend received to give a taxable income to the shareholder of $1. The taxpayer is then charged tax on the $1 of income and receives a tax credit of the amount of tax already paid on their behalf by the Company. If in the above example the taxpayers tax rate is 40% then the tax payable on the $1 income is 40c. 30c has already been paid by the Company so only a further 10c is payable.

You can check that this is correct. The profit was $1, the taxpayer received 70c and paid 10c in tax, leaving them with 60c which is the same as $1 less 40% tax.

Its actually harder to explain than do. Dividend certificates always show the franking credits in dollars and cents attached to any dividends. All the tax payer has to do is add that franking credit amount to their total income, calculate their tax and then subtract the franking credit amount.

When I am examining the dividend return for a Company I always gross them up. This enables me to make a fair comparison between alternate investments. Grossing up the dividends of all investments yields to a level playing field. In the end it tells me how much I will receive as income that I will need to include as taxable income on my tax return.

For a dividend that is 100% fully franked (as CST is) the simple way to gross up the dividend is to divide by 7 and multiply by 10. That grosses up the recent 2c dividend to 2.85c.

If you have money to invest and want to compare, for example, the interest rate on a Bank IBD and a dividend return, it is essential to remember to gross up the dividend. A 4.9% fully franked dividend gives the same return as a 7% IBD. 

There is another reason, aside from return comparisons, that we might be interested in franking credits and grossing up. 

Whilst the tax rate for Companies in Australia is 30%, our own tax rates may be higher or lower. If we hold our shares in a Self Managed Super Fund that is in pension mode then our tax rate on income is zero, zilch, nothing (I just like saying it). That means that if we receive 70c of fully franked dividend from the Company then at the end of the year, when we do our tax, the Government will send us another 30c (ie the tax that the Company paid on our behalf that the Government doesn't want).

So, in the end, when we are looking at the returns from a shareholding it can make sense to look at PBT (even in the absolute sense).