This article originally appeared on HBR.org.
The new U.S. tax law is likely to increase after-tax cash flows for U.S.-based companies by anywhere from 10% to 20%, depending on their current tax position. As we approach earnings season, investors should listen carefully to what CEOs plan to do with the money. There's a strong argument that they should invest in growth, and the newly available cash offers them a unique chance to do so. Unfortunately, too many are likely to squander the opportunity.
The size of this windfall is remarkable, and it comes from several sources. The new law reduces the statutory corporate rate from 35% to 21%. It permits immediate expensing of many capital investments. It treats pass-through entities more favorably than in the past, and it increases the incentive to repatriate off-shore cash. In a world already awash in investable capital, these changes should further widen the spread between after-tax investment returns and capital costs, driving up multiples.
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Initial reports suggest that many executives are at a loss as to what to do with the newfound cash. A few have announced year-end bonuses (AT&T, Comcast) or wage increases (some retailers). But most have been reticent to say anything about their plans. At a recent investor conference, one of us heard a CEO proudly state that the new law would have no effect at all on how his company views investments.
One option, of course, is to drive up the stock price by buying back shares, and some CEOs may choose that course. But in light of the run-up in stocks over the past year, buybacks have become more expensive than ever. Surely there is a better use for the additional cash.
Why are CEOs so reluctant to pursue bold new investments in growing their companies? Our research and experience suggest that many executives underestimate the value of growth, specifically in today's low-interest rate environment, and are thus missing out on a chance to make their businesses much more valuable than they are today.
Consider some simple math. The intrinsic value of a company with growing cash flows doubles every time the discount rate is cut in half. (The lower the discount rate, the more that future cash is worth.) So, value grows exponentially as the discount rate approaches zero. The cost of capital is at historic lows, averaging below 6% for most large U.S. companies. In this environment, small increments to growth are highly valuable. Indeed, for most companies, the value of accelerating growth greatly exceeds the value of returning capital to shareholders.
Growth-oriented investments aren't hard to recognize. For example, well-managed consolidators such as Dell Technologies are doing well in this market. And Apple's plans to repatriate billions in cash from overseas, open a second campus, and expand its workforce by 20,000 over the next five years is a clear case of investing the tax windfall to fuel growth.
But, for most companies, outsize returns are likely to come from three other sources:
Investing in productivity-enhancing capital. The tax law allows 100% expensing of much new capital expenditure. In a world of tight labor markets, where recruiting and retention are at a premium, investing to make frontline employees more productive should be a priority. Working with its franchisees, Dunkin' Brands is planning to remodel its stores and bring in new equipment. The goal is to increase efficiency while providing a better consumer experience.
Investing in true innovation. The Googles and Amazons of the world should not have all the fun. If there was ever a time to confront the innovator's dilemma and make your old business model obsolete by developing new products and services, that time is now. Remember how Netflix transformed itself from a mail-in DVD business to an online streaming company with proprietary content? Plenty of other companies can do something similar, if only they have the imagination.
Investing in the supply chain. Supply chains are undergoing a transformation in almost every industry we study. For example, the old paradigm of distributing goods to consumers through self-selection in retail stores is breaking down and not coming back. The winners in many industries will be companies that figure out how to go from production to consumption in the most effective and efficient fashion. Wayfair, the online retailer of home goods, is building out a dedicated supply chain optimized to fit the bulky, low-value-to-weight characteristics of its product line.
Let's hope more executives begin to think like these companies. After all, this is an opportunity that won't come again anytime soon.
David Harding is an advisory partner in Bain & Company’s Boston office and the former leader of the Global Mergers & Acquisitions practice. He is a coauthor of Mastering the Merger: Four Critical Decisions That Make or Break the Deal (Harvard Business School Press, 2004).
Michael Mankins is a partner in Bain & Company’s San Francisco office and a leader in the firm’s Organization practice. He is a coauthor of Time, Talent, Energy: Overcome Organizational Drag and Unleash Your Team’s Productive Power (Harvard Business Review Press, 2017).
Karen Harris is the managing director of Bain & Company's Macro Trends Group and is based in New York.