A low P/E ratio in the old days meant that a company was overvalued. However, accounting has changed a lot since.
I'd like to share an example that I recently stumbled across – Nokia.
This post will also include some explanation related to tax loss carry forward, so if you're not familiar with that, that will change by the end.
Nokia has a P/E below 5. Prior to publishing the 2022 results, the P/E was 13. This means there was a HUGE increase in earnings (more than double). During the last year, the share price was down 18%, which seems a bit odd, for a company that just doubled its earnings, right?
Well, there's a good explanation for that.
Take a look at the following data:
2020: Profit before tax – EUR 743 million (Tax expense – EUR 3.3 billion)
2021: Profit before tax – EUR 1.9 billion (Tax expense – EUR 272 million)
2022: Profit before tax – EUR 2.2 billion (Tax benefit – EUR 2 billion)
It seems that 2021 is the only year with a reasonable ratio between the expense and the profit before tax.
So, what happened in 2020 and 2022? Here's where tax loss carry forward comes into place. I'll try to elaborate with a simple example.
Imagine that you've started a business, and in the first year, you had a loss before tax of $10,000. In the majority of the countries, you can “carry” this loss forward into the next year, and use the losses to offset the profits.
Let's imagine your business had a profit before tax of $5,000 in year 2. Since you have $10,000 in losses carried forward, you can use half of that, to not pay taxes in year 2, and you still have $5,000 to carry forward in year 3.
Now, in year 3, the business did better, and your profit before tax was $8,000. Well, after using your last available losses, you have a tax base of $3,000. Let's assume that the tax rate is 25% –> You have to pay a corporate income tax of $750.
How is this reflected in the accounting of the company?
At the end of year 1, the $10,000 losses will help you not pay taxes of $2,500 ($10,000 * 25%). This will be shown as a deferred tax asset.
At the end of year 2, there are $5,000 losses still left, so the deferred tax asset will now be $1,250.
At the end of year 3, there won't be any deferred tax assets arising from losses.
In some countries, the losses can be carried forward for 3 years, in some 5, and in some indefinite.
However, losses from one country cannot be used to offset profits in another country.
So, if this is so simple, how does this explain the Nokia example above?
There's one catch. If the company is not expected to use these losses against profits on time, the company is not allowed to recognize a deferred tax expense. Otherwise, it would be misleading investors that they'll pay less taxes in the future.
Here's an extract from Nokia's annual report:
“In 2020, Nokia de-recognized deferred tax assets in Finland, due to a regular assessment of our ability to utilize deferred tax assets in Finland for the foreseeable future, which was done primarily based on our historical performance.
At December 31 2022, Nokia concluded, based on its latest assessment, that it is probable that it will be able to utilize the unused tax losses and deductible temporary differences in Finland and re-recognized deferred tax assets of EUR 2.5 billion“
All of this is a fancy text that basically says:
In 2020, they expected the company not to be profitable on time, in order to use the losses the company generated in the past. So, the deferred tax asset that was previously recognized, is derecognized.
In 2022, this has changed, as the profitability in Finland improved, and now it is likely that the company will generate profits and be able to use the previously generated losses on time.
This event led to huge swings in the income statement (and balance sheet) both in 2020 and 2022.
If we adjust the result of 2022 for the 2.5 billion, the net profit is closer to EUR 1.7 billion (vs. EUR 4.4 billion reported), so the P/E ratio of 4.8, is actually above 12.
I hope that you enjoyed the post!
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