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Yesterday morning, Warren Buffett appeared on CNBC's "Squawk Box" for 3 hours. His interview covered a variety of topics. One topic of interest to me was Apple (NASDAQ:AAPL). I have always admired Buffett and recently wondered what his take on Apple would be. When asked what he would do if he were running Apple, he said he would ignore David Einhorn's preferred shares proposal and instead focus on building long-term value. He suggested buying back stock. He recalled a conversation with Steve Jobs a few years ago: "When Steve called me, I said, 'Is your stock cheap?' He said, 'yes.' I said, 'Do you have more cash than you need?' He said, 'a little.' [laughs] I said, 'then buy back your stock.' He didn't ... But if you could buy dollar bills for 80 cents, it's a very good thing to do." He also added: "Berkshire has gone down 50 percent four times in its history. When that happens, if you've got money you buy it. You just keep working on building the value."

Listen to Buffett

In the past few months, Apple's stock hasn't quite dropped 50% but 40% still represents a steep decline. As for cash, the company sure does have plenty of it. The company has $40B in the U.S. and $97B pretax dollars overseas. Scenario 1 below shows what would happen if the company bought back stock with the U.S. money and Scenario 2 shows what would happen if it brought the foreign cash into the U.S., paid a conservative estimate of 35% in taxes on it, and then bought back stock with that as well. The EPS calculations and forward P/E calculations assume no growth in net income from current TTM numbers to fiscal 2013 numbers. The dividend calculations use the TTM dividend of $10.60 per share.

Apple has the opportunity to provide its shareholders with an immediate 35% EPS increase and save itself $2.6B annually in dividend expenses. It seems like a no brainer to me. It takes most companies a little over 3 years to increase earnings by 35%; Apple has the opportunity to do it instantly.

The Buffett Thinking

Warren Buffett always stresses the importance of logical capital allocation. He believes that businesses should always allocate capital in places where they achieve the highest returns for shareholders. If this is the case, then we should compare the return from the stock buyback to the returns the money would achieve if reinvested into the business. The best we can do is assume Apple would earn a return on the cash equal to its current ROA but there are no guarantees of this. In fact, faced with increased competition, it is likely that the return would be materially lower.

So essentially Apple has the choice between buying back stock and delivering a 35% return to shareholders or reinvesting the cash and delivering a 21% (likely lower) return to shareholders. Account for the $26B the company will save in dividend expenses over the next 10 years by buying back stock and the choice seems obvious.

Why Act Now?

Apple already has a small buyback plan in place so why expand it now? Apple's current buyback plan is nothing, it doesn't even outweigh the dilutive effect of stock-based executive compensation. Furthermore, Apple stock is currently at a 52-week low of $420 per share.

(provided by finviz.com)

The effects of the buyback are inversely related to stock price; the lower the price is, the bigger the returns the company and shareholders will receive. Also, keep in mind that the buyback would take time. Apple could not just buy back over a quarter of the shares outstanding at one time without causing a massive increase in stock price. The company would have to pay much more than $420 for much of the shares if this happened, making the buyback less effective. No, the best way for this to be done would be to announce the buyback to the extent that is legally required, and say no more of it. As ridiculous as it sounds for the most followed company in the world, it should keep the buyback on the "down low." The company could then go about repurchasing shares gradually at lows, being careful not to buy so much at a time as to drastically increase demand. The company could create some sort of system like what Buffett does at Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B) of repurchasing shares whenever price-to-book value drops below 1.2. The logical thing to do in my opinion would be to only repurchase shares when the total return of doing so (EPS increase plus dividend expense saved) exceeds ROA. Right now, that's the case, so it's a good time to buy.

Other Reasons to Buy Back

Besides the optimal return the buyback would deliver to shareholders, there are a few other reasons for the move. Apple's stock price has been punished by investors recently. Sentiment is clearly negative right now. The logical solution to this problem is to identify the biggest criticisms of the company and then take action. Two of the biggest criticisms of Apple right now are that the company is doing nothing with its cash hoard and that the company is too large to achieve continued growth. Using the cash hoard to buy back stock solves both issues. It not only is a shareholder friendly use for the money, but it also dramatically reduces the size of the company. If the company wants stock price to change, it must first take action to change sentiment and a buyback would do that. I believe the price would significantly increase if such a buyback was enacted. In his interview, Buffett said, "You can't run a business to try and run the stock up every day." I agree with Buffett; if these were the only reasons for the buyback, it wouldn't make much sense. But he also says, "I would run the business in such a manner as to create the most value over the next five or 10 years." My calculations above show that, right now, a buyback does in fact create the most value for shareholders. Also, it should be mentioned that the buyback is much more attractive than a large one-time dividend, large quarterly dividend increase, or preferred shares issuance because the buyback saves the money from being double taxed. I could cite many other reasons for doing so, and they're all just bonus - just icing on the cake.

It is executive management's job to allocate capital in places where it generates the highest returns. Right now, buying back stock generates the greatest returns by far. Therefore, management should buy back stock until the returns from doing so are equal to ROA. It's really as simple as that.

Source: Buffett Has The Solution For Apple