No dividend, no worries

By Felix Salmon
November 30, 2011
Karl Smith made a funny point in response to my post about Apple's falling p/e ratio: since Apple's not returning any money to shareholders in the form of dividends or buybacks, he says, shareholders aren't getting any return on their investment.

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Karl Smith made a funny point in response to my post about Apple’s falling p/e ratio: since Apple’s not returning any money to shareholders in the form of dividends or buybacks, he says, shareholders aren’t getting any return on their investment.

Unfortunately, Matt Yglesias didn’t seem to get the joke:

The crux of the matter, as I see it, is Apple’s ever-growing cash horde which went from $70 billion in liquid assets at the end of Q2 to $82 billion in liquid assets at the end of Q3. The company is earning huge profits, which is great, but since it seems determined to neither return those profits to shareholders nor to re-invest them in expanded operations it’s hard to see how investors aren’t going to discount the value of the enterprise.

This is trivially wrong. If Apple’s cash pile is growing, that will increase its p/e ratio, rather than decrease it. On April 20, Apple reported Q2 earnings of $6.40 per share, or $20.98 over the previous 12 months. It closed the following day at $350.70, which corresponds to a p/e of 16.7 on a TTM basis. On July 19, Apple reported Q3 earnings of $7.79 per share, or $25.26 over the previous 12 months. It closed the following day at $386.90, which is a p/e of 15.3 on a TTM basis. The earnings were up, the price was up, but the p/e ratio was down.

Now Apple has roughly 1 billion shares outstanding, so let’s say that its “cash horde” went from $70 per share to $82 per share over the course of the third quarter. That’s more than 20% of the share price, right there. Take the cash away, and the p/e ratio falls to just 12. Even if you value the cash horde at just 50 cents on the dollar, the p/e ratio still falls, to 13.7 from 15.3.

It’s possible that shareholders would like to receive the cash as a dividend payment — although if and when that ever happens, they will have to pay income tax on it. They might even value Apple more highly if they can see themselves getting a modest income from their Apple stock without having to sell any shares. But we’re talking very marginal effects here: there’s no real sense in which turning a dollar of cash into a dollar of dividend payment increases the value of a company. Indeed, once the dividend is paid, the stock price will go down, since it no longer reflects the value of that cash.

I suppose it’s theoretically possible that investors are valuing Apple’s cash at zero, on the grounds that they’re never going to see any of it. But even if they are valuing the cash at zero, that doesn’t change Apple’s p/e ratio, which is still falling. What makes no sense is Yglesias’s idea that Apple with zero cash would somehow be worth more than the same company with $82 billion in the bank.

Smith’s point is a bit more subtle, and is probably best expressed in terms of the theoretical idea that a company’s share price should equal the net present value of its future dividends. If it never pays a dividend, and will never pay a dividend (or get bought), then the value of the company is zero.

I’ve been critical of Berkshire Hathaway’s no-dividend policy, but largely because the company’s shares are so ludicrously expensive that you can’t raise cash by selling just a few of them. Anybody who started with a decent Apple shareholding and then rebalanced annually to keep Apple a certain percentage of their total portfolio would indeed have received very healthy cash dividends, over the years, from the proceeds of all the shares they sold. And meanwhile, Apple’s shareholders get to hold on to all of the company’s earnings tax-free. (In fact, insofar as those earnings are kept overseas, they’re saving on tax twice: first when Apple repatriates the money and pays corporate income tax on it, and secondly when they pay personal income tax on their dividend income.)

It’s very easy, of course, to run a discounted cashflow model on Apple: such things model earnings, not dividends. And although there are some mutual funds which only invest in stocks which pay a dividend, I don’t think their absence from Apple’s shareholder base explains any part of its low p/e ratio.

And in any case, the joke behind Smith’s post is just that even if the lack of a dividend can explain a depressed p/e ratio, it can’t explain a falling p/e ratio. No one expected Apple to pay any dividends two years ago, when the stock was trading on a p/e of 32. Why should they suddenly care about such things now?


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Yglesias wrote: “nor to re-invest them in expanded operations”

Except they do, by dropping vast sums of money on suppliers in order to get priority access to crucial manufacturing capacity, finished components, or tools, to the extent at times of buying up all existing capacity, which keeps the competition from getting their hands on it.

Posted by jonhendry3 | Report as abusive

The comparison to BRK isn’t quite fair, as Berkshire’s business model can be reduced to “we reinvest your dividends better than you ever could.” So far, for better or worse the corporation has a track record for it.

What I would be worried about in Apple’s case is that management might not be as capable of deploying large sums (which have since grown to extremely hard to manage $82 bn). If Apple cannot employ the money in its propper business, it should return it to shareholders, to do with as they see fit.

The most frightening example of profitable business generating cash piles to vanish was Daimler-Benz in the 90s. Management became megalomanic and destroyed the cash legacy of decades in a binge of ill advised M&A. Apple’s management used to be unique. Now it is great, but what will the future hold?

Posted by Finster | Report as abusive

Are you not confusing book value with stock price? The cash “hoard” might raise the book value but not necessarily the stock price. And the PE ratio relates to earnings vs. stock price, not book value. Companies can earn more steadily but the stock price goes nowhere if the PE ratio declines. And the PE ratio is really the market’s estimate of future earnings. It is a psychological thing, not quantifiable.

Posted by Chris08 | Report as abusive

Charles Krauthammer and the House GOP delegation say that Treasurys are “just pieces of paper,” maybe that’s why the market is discounting Apple’s cash hoard, which is made up of government securities on which the GOP would like to default.

Posted by johnhhaskell | Report as abusive

Not sure you really get this Felix. Earnings growth drives the price. A growing cash pile signals fewer investment opportunities and hence lower expected earnings growth. This lowers the price and hence the p/e, even allowing for the fact that more cash is obviously a good thing.

Agree cash piles – all other things being equal – increase the p/e but all other things aren’t equal and it is what they signal about future earnings opportunities that matters more.

Posted by cb22 | Report as abusive

if you think harder you would probably find the answer. Plus p/e is not the only way to value a company

Posted by Tseko | Report as abusive

You are definitely correct that cash increases the P/E ratio of a given stock. Too much cash on a company’s balance sheet will be penalized for a variety of reasons. Especially when you’re looking at Apple, where the cash is more like a horde than a strategic resource. There’s no way they could invest that amount of cash in any reasonable time frame. Then you start thinking a little deeper about it and realize that it deserves this penalty.

First, a good chunk of cash is housed overseas and will be taxed at some point. So $1 of cash in an overseas bank is more like $0.75 of cash in a US bank. That’s for starters. Next you can look at some of what Apple management has indicated it would do with the cash. It really stands out in my mind that Steve Jobs, in his bio, said that he would spend “every last penny” of Apple’s cash in order to bring down Android. That’s not exactly the type of statement that indicates to shareholders cash will be deployed prudently.

But more realistically, the rule of large numbers probably has a whole lot more to do with Apple’s shrinking P/E than its cash balance. As you get bigger and bigger it becomes harder and harder to grow. That growth is discounted in the P/E. Further, Apple’s margins are so incredibly high in its dominant markets that it encourages competition. There’s a reason why dominant tech companies have a hard time staying dominant. This is especially a concern with a company that relies on generating premium margins on commoditized products than it does one with a strong purely IP-based moat. Apple is now being attacked from all angles, and its innovations are even cannibalizing itself now.

Posted by offpeak34 | Report as abusive

Felix, stock prices are more sensitive to future earnings expectations than to book value (or even current earnings performance). P/E is just one very roughly valuation tool — even fundamentals-driven investors know better than to rely on it too heavily.

$1 of annual earnings will typically translate to $12-$16 of share price. $1 of cash hoard held in overseas accounts translates to $.65 of share price. Maybe. If you trust management not to waste it.

And why should we trust management not to waste the cash hoard? Investors have been burned **SO** many times in the past. Just a few months ago, HP decided that it had $10B of excess cash. It could have issued a $5/share dividend. It could have used the money to repurchase 200M+ shares (10% of the float). Instead it “invested” the money in some never-before-heard-of company that doesn’t offer any synergies with HP’s core businesses.

I could have made THAT investment myself, and I wouldn’t have needed to pay a massive acquisition premium on top of the share price.

You can reasonably argue that Apple’s management is more trustworthy than HP’s. Still, they have a new CEO and are facing a new situation. Never before in their history have they been sitting on $70B+ of excess cash. Yes, they are using that effectively to invest in R&D and in their supply chain. But they won’t — can’t — spend $70B that way. They can’t even keep up with their current cash flow that way (the cash hoard continues to grow rapidly).

If you value that $70B of cash hoard at $70B, you are doing it on blind faith more than any real knowledge that they know how to use it effectively.

P.S. An April-July comparison of stock price is just silly. Fundamentals matter over the LONG term, but three months is absolutely SHORT term. I can’t believe you tried using that to support your argument!!!

Posted by TFF | Report as abusive

Felix, you are trivially wrong.

Taking your $12 of cash in the Q and annualising to $48 and paying THAT out every year as a dividend gives you a 13% (gross) yield on a $370 stock price.
(Or if you would rather use earnings take the TTM $21 gives a 6% yield.)

So what would you rather?
Zero cash on balance sheet with 6-13% yield (AND GROWING) or growing cash pile you will never get your hands on?

Of COURSE there is a very real sense (in some circumstances) that paying a dividend increases the value of the stock.

If the general consensus is that no one is ever going to see a penny of the cash then effectively it is valued at zero.
If you suddenly agree to pay it out that cash ceases to be worth zero, so the stock price will go up.

For example, check out the recent announcements by cable companies Virgin Media and Kabel Deutschland.
They both reached sustainable balance sheets and sustainable FCF so agreed to pay out the excess cash. BINGO – multiples go up…

The problem for Apple is FAR more subtle however.
IF they pay out the cash – they are effectively admitting that there is no better investment for them to make with it than they believe the shareholders could make for themselves.
That involves Apple management eating a fair slice of humble pie, which would be an unheard of Jobsian event.

As Jon Hendry pointed out – they spanked gobs of cash on NAND JVs in order to guarantee supply and create a very important cost advantage.

Maybe they are saving up for Facebook.
Who knows.
The point is they have shown a VERY GOOD history of value creating investments (way over cash value) so the cash certainly isn’t worth zero.

The multiple is contracting because growth is slowing.
Feel free to look up the Gordon Growth model of valuation.

Posted by TinyTim1 | Report as abusive

“Maybe they are saving up for Facebook.”

That only makes sense if Facebook is worth more (perhaps 30% more) **TO** **APPLE** than it is as an independent entity.

Major acquisitions are frequently value-destructive to the acquiring corporation. They only make sense when there are clear synergies that can be exploited to increase the value of both the acquired property and existing franchises.

Greater value typically derives from a large corporation acquiring much smaller ones. The acquired property benefits from access to the cheap capital and large sales force of the acquiring company. Unfortunately for Apple, it is very hard to spend $70B through small acquisitions.

Posted by TFF | Report as abusive

Oh also – people have to pay capital gains tax too.
Often companies use a mix of buybacks and dividends to appease different shareholders.

The DCF valuation is only valid if you assume ALL the earnings are paid out as dividends.
NOT paying out the earnings in the year earned means you would have to push that cash into a later year and give it a greater discount.

Just “DCF-ing” Apple’s earnings is clearly the wrong way to value the company. You should assume a multi-year ZERO for cash paid out with a whopper special dividend at some point in the future followed by an ongoing dividend stream.

OR you assume higher growth in future cashflows as Apple invests in taking greater share or buying another business, for example.

Lastly you are SORT OF right that OFTEN multiples will contract as a stock moves from a growth to an income type investment.
Again, at that point the management team are pretty much throwing in the towel.
They are admitting that they have no ROIC investment that is better than cash in their shareholders’ pockets.

So then you take a view on the sustainability of the dividend and discount appropriately to give you a required yield.

Posted by TinyTim1 | Report as abusive

With respect TFF that’s total rubbish.

It is perfectly possible for a company to acquire another company simply because they see it as fundamentally cheap.
You are assuming that the acquired company is trading at fair value or fair value HAS to be paid for some reason.
Pay Pal is probably the best example I can think of off the top of my head.
Tremendous value creating acquisition of what in hindsight was a far too cheap company.

I will admit that it VERY RARELY happens because often the board will force a high premium and will have an inflated sense of self worth in most cases.

Also I would 100% agree that tech companies generally have a fantastic history of destroying value or overpaying in M&A.
AOL, Skype anyone?

Posted by TinyTim1 | Report as abusive

“It is perfectly possible for a company to acquire another company simply because they see it as fundamentally cheap.”

Sure, in theory, but if the company is “fundamentally cheap” then why don’t they have other suitors? This is perhaps most common in the middle of a financial meltdown when there are few companies with cash to spend (and many in distress).

“I will admit that it VERY RARELY happens because often the board will force a high premium and will have an inflated sense of self worth in most cases.”

Thus my use of the qualifier, “frequently value-destructive”. Guess I should have qualified the next line as well. :)

I’ll try to evaluate any given acquisition on its own merits, but a hypothetical acquisition of Facebook by Apple doesn’t sound to me like one that would add value. On the contrary, your phrase “inflated sense of self worth” would seem to apply.

Posted by TFF | Report as abusive

I think Felix is basically right here, as he’s looking at it from real-world perspective while Yglesias, unsurprisingly, takes more of a textbook view.

A stock’s P/E is determined by the relative spread between the firm’s return on equity over its cost of equity capital. The higher the relative spread the higher the P/E.

“Cash hordes” lower your potential return on equity for the next earnings cycle, all other things equal. That decreases the spread mentioned above and lowers your P/E, all other things equal. Here’s where Matt has somewhat of a bit of a point to make, but…

…he ignores leverage. In the real world, you likely would not keep “all other things equal.” Rather, you would maintain your leverage (debt for most companies but essentially working capital for apple) to keep up with the growth of the “cash horde.” Essentially this is the “reinvest for growth” idea. Then, so long as you continue to invest in assets that support your historical cost of equity while earning the same or higher return on equity as before (apple can do this by simply expanding existing operations), your P/E can remain unchanged or even grow, regardless of the absolute size of your “cash horde.”

So to me the question is: can the shrinkage of apple’s P/E be explained by lower return on equity over that same period? That’s the only real way that Yglesias’s “cash horde” argument would make sense.* Nope – apple’s return on equity has steadily increased over the past several years. This round goes to Felix.


*You could also explain this via a significant increase in apple’s cost of equity capital but I’ll let others make that argument if they’d like to.

Posted by ISOK | Report as abusive

Should be “cash hoard” (even though “cash horde” is pretty funny).

Posted by AlanVanneman | Report as abusive

TinyTim1, Apple is nowhere near stupid enough to buy Facebook. Facebook just isn’t profitable enough to warrant an acquisition by Apple. While FB allegedly has more users than Google, their rumored revenue is not only a fraction of Google’s revenue, but less than Google’s profits. Other than their basic premise of a social network, they have not introduced any innovations, either. They are allegedly seeking an IPO that would value them at $100B, and Apple just isn’t going to buy a company solely because they think somebody else might pay more for it, which, while we’re talking about it here on this thread, is what really drives stock prices these days.

There’s a lot of comments here about what drives the stock price, and I wish even one of them was consistently true. Then all you would have to do to make money in the stock market is figure out which companies were going to grow their profits, and apply the universal valuation model. But performance and growth take a back seat to emotions and interpretation of external events (the US debt ceiling, Greece, Italy, oil prices, etc.), rendering P/E, cash, growth rate, and all of the other metrics relatively meaningless.

But Apple buying T-Mobile, that’s another story (or wishful thinking).

Posted by KenG_CA | Report as abusive

“There’s a lot of comments here about what drives the stock price, and I wish even one of them was consistently true.”

In the long run, fundamentals win. :) But like liquidity crises, you need to be in the investment for the long run.

Note that buying Walmart at a P/E of 50 pretty much guarantees you mediocre long-run returns no matter if profits triple over the following decade. The fundamentals of buying an investment with a P/E of 50 are miserable.

In the short run, prices are driven by market sentiment and inefficiencies tend to be persistent for several months.

Posted by TFF | Report as abusive

“In the long run, fundamentals win”

How long is the long run?

Posted by KenG_CA | Report as abusive

“How long is the long run?”

When we’re all dead.

Posted by zdneal_2 | Report as abusive

Depends on the situation, KenG… Took ten years for Walmart’s price and fundamentals to converge. Finally, in the last few months, it seems to be reversing a little. Has less to do with its operating success than with the ridiculous valuation it was trading at a decade ago.

In contrast, I expect the market to separate the winners from the losers in pharma within five years. (Right now the whole sector is trading at a discount.)

Remember that a better company should ALWAYS trade at a higher valuation than one in a similar industry that is less well run. Plenty of examples of that, pricing differences that persist indefinitely (with good reason).

Posted by TFF | Report as abusive

If you thought Wal-Mart at a P/E of 50 was nuts, you must really love Amazon at 100. Great company, lots of room to grow, but 100? I used to own it, but thought it couldn’t sustain a P/E of 70, so I sold it. I know at some point I will be right, but that is little consolation for selling it before it triples.

Posted by KenG_CA | Report as abusive

Similar logic, KenG. Amazon essentially needs a decade of 30% growth to justify that price. Not impossible, if they can become a player in some new games, but that is a VERY difficult call to make with any confidence.

I long ago reconciled myself to the fact that I won’t own every winner in the market. For that matter, I will rarely own ANY of the big winners. And that is perfectly fine with me as long as I can continue to successfully avoid the big losers. The natural trend of the stock market (even in these weak economic times) is strongly positive as long as you can stay away from those that go bust.

Posted by TFF | Report as abusive

Alas, educating Felix seems to be the point of this blog. And we are all willing to do it. Why in the world does a financial publisher like Reuters assign an art and philosophy major to cover business issues. As sign of the times, I suppose.

Posted by Marphatexas | Report as abusive

I believe that the author has confused two fundamental items: price to earnings ratio and price to book ratio. Piling up stacks of cash improves the P/B, not the P/E. A good P/E may contribute to a healthy P/B but they are independent even if they often correlate nicely.

Posted by ylime1 | Report as abusive

“It is perfectly possible for a company to acquire another company simply because they see it as fundamentally cheap.”

A company should never acquire a company just because it is Cheap, they should only do so if the acquisition adds value to their core business.

If they have extra money they should give it back to their shareholders who can invest in all the cheap companies they want.

Posted by AASH | Report as abusive

$82 billion may not seem like a big number to Apple, a quick mental calculation says it is equivalent to just 9 months revenue, and that’s before taxes and reservations. In the tech world, you never know how successful your next product will be and may need a cushion to weather a hole in sales. You might have forgotten, but Apple never has, how close they came to going bust.

As has already been said, the money is used to protect the supply chain (eg a few years ago when they bought 67% of the world’s NAND chip memory – was it worth $5 billion?) to invest in collaborative and innovative hardware production methods with suppliers (eg the recent $1 billion deal with Sharp for displays), to buy smaller but technology brilliant companies for their technology (that’s how Siri got to the iPhone) and to be able to survive in hard times without having to cut training budgets as HP have done and to invest in products that they can refine in the market place even if they start out being unpopular (eg Apple TV).

As for the share price, I suspect the old argument used against Microsoft is being applied here, that increasing dividends (or even paying one) could increase demand for the company’s shares from pension funds and other large investors and thus increase the share price.

Microsoft did indeed start paying out dividends, and when Vista flopped their expected new income flows didn’t materialise, and as a two product company with half of their business off kilter they then lacked enough money to sort themselves out so we’ve had quite a few years of pretty flat growth, compared to Apple’s meteoric rise.

Posted by FifthDecade | Report as abusive

“they then lacked enough money to sort themselves out”

First I’ve ever heard THAT excuse applied to Microsoft. Do you realize they are sitting on $50B of cash, growing by $10B+ annually?!?

Microsoft’s problem is a lack of innovation, not a lack of resources. They are still trying to reinvent the iPhone and iPad.

Note also that Microsoft’s low dividend payment limits their ability to leverage a higher P/E. They presently offer a 3.2% dividend, which is okay but nothing special for a slow-growing behemoth. Doesn’t matter that their P/E is just 8.5 when they refuse to share most of that cash with their stockholders.

If they pumped a 45% payout rate — safe given the stability of their earnings and financial strength — you would see a lot of ears perking up at the 6%+ yield and I bet the share price would nearly double. The dividend yield mostly offers a “floor” to the stock, so a low dividend payout provides a low floor.

If Apple were to initiate a $5/year dividend, nobody would care. If they were to pay a $20/year dividend, you would see the stock jump.

Posted by TFF | Report as abusive

Another point is that the book value of Apple is increasing as they hold on to retained earnings. Assets, after all, do have value. Especially cash. If they are able to continue growing revenues without reinvestment of capital, why not keep the asset as cash? In the future if Apple finds a project they estimate will warrant an investment of capital for lucrative future returns in a more friendly business climate, they will have the capital on hand to do so. Why invest the money now in an unfriendly business climate with a low expected return? Obviously, Apple sees what a lot of other businesses see now, regardless of political rhetoric. There is not a lot of confidence that in the future, there will be a market for the public to adopt new innovations in a stagnant economy. If the risks of the cash investment losing value didn’t outweigh the probable expected return on the reinvestment, they would be reinvesting. If all it took to raise a stock price was to pay dividends, every company would be paying out everything they could in dividends. Plus the tax implications already pointed out.

Posted by Anonymous | Report as abusive