The institutional pressure on Apple (NASDAQ:AAPL) to pay dividends has been slowly destroying value for individual investors. Recently, Apple has grown its dividend under the pressure of major institutional shareholders, most prominently David Einhorn of Greenlight Capital (NASDAQ:GLRE) (a great stock to own as well). Institutional investors do not pay capital gains taxes at the 20% rate, which individuals do and therefore are happy to receive dividends when shares are fairly priced or overvalued. Even when shares are cheap they may encourage dividends over share buybacks in order to put a "floor" on the share price.
There is a plethora of valuation articles on Apple so I will only cover it briefly. While future innovation is the growth driver at Apple, assuming flat earnings, the stock net of cash and liquid investments is trading below 6.2x FY '13 estimated earnings, representing a strong discount to mature technology companies. In fact, in an ultra-conservative valuation assuming -25% earnings growth and an applied multiple of 10x earnings the shares are still undervalued.
Dividends are an often attractive way for a company to return excess cash to investors and to set a "floor" on its share price. Effectively, should the share price fall, the yield will rise until investors are willing to ensure the yield offsets equity risk. In Apple's case, under intense selling pressure, it's a way to absorb and soften the landing.
Buybacks on the other hand return cash through shareholders via negative dilution. While as Warren Buffett points out, companies have a history of overpaying for their own shares, and end up destroying shareholder value in the process. In the case of an undervalued company, these buybacks are a great way to build shareholder value. The effects of a well-executed repurchase program with a subsequent rise in share price is a far-better method of returning value to shareholders than dividends. In addition to its dividend, Apple also has a $60 billion share repurchase program in place.
Scrap the Dividend
Assuming the market fairly prices an asset (or even moderately overprices it), share repurchases are a better form of capital return to the typical individual investor. This holds true because the investor immediately pays a 20% capital gains tax on the dividend, while under a share repurchase the capital would compound growth, with taxes deferred until the sale of the asset. It is important to note that an income investor holding shares in a Roth IRA on another tax-free account will have lost value if the shares were repurchased at a premium.
When it comes to Apple, a value investor should be a proponent of halting the dividend and reallocating the funds to a larger share repurchase. This is because there is immediate creation of value for the shareholder via the retirement of cheaply-bought shares (even if the stock is held in a tax-free account).
The individual long-term value investor should be a proponent of capital return (to echo every analyst in the sector, Apple has far more cash than it needs on its balance sheet) in a flexible program which reflects current share price. Right now the better option is the repurchase.