Although there are a lot of Apple (NASDAQ:AAPL) shareholders out there that are not satisfied with the company's share price in the $530s right now, the lower price has actually been a blessing for the truly long-term shareholders, because the lower prices serve to increase the effectiveness of Apple's stock buyback program.
When Apple began buying back shares in 2012, I was initially concerned that the stock buybacks would serve as a thinly-veiled guise to just mop up shares created as executive compensation, and I was also worried that Apple would buy back its shares at such a slow place, that it would make the share buyback program essentially a meaningless factor in explaining the company's per share earnings growth.
I've been pleasantly surprised so far to see that those concerns are misguided. The company has reduced its share count from 940 million in 2012 to 899 million by the end of 2013. That's a share count reduction of 4.25% in one year, which puts Apple in that "buyback royalty" category with Exxon and IBM.
What makes Apple intriguing for dividend growth investors is that the company only needs to hold on to a small percentage of revenue to fund future growth. More specifically, it only needs to hold on to 6.2% of its $170 billion annual revenue stream to maintain its competitive position (and even build its moat) and ensure satisfactory core earnings growth going forward. That works out to about $10.5 billion.
Right now, Apple is making $37 billion in annual profits. It is paying out $10.9 billion in annual dividends (based on the latest share count of 899 million, as opposed to the sites that use weighted averages for the share count and are slower to adjust). It needs $10.5 billion in profits to be retained for the core business. In other words, there are $15.6 billion in profits that can go towards buybacks, and over time, represents the company's capacity to increase its dividend payout ratio.
When a mature company initiates a dividend, it doesn't usually just starting paying out half of its profits to shareholders all at once. It's usually done on a gliding scale, and I think Microsoft's model of dividend growth is loosely analogous to the maturation we can expect with Apple's dividend. It essentially took Microsoft a decade to get its dividend to 40% of profits, and Apple is moving at a moderately faster pace (Apple managed to get its dividend up to 30% of earnings within three years). In other words, Apple will probably get its dividend up to the 40% of profits mark within seven years, rather than ten like Microsoft.
That is why it is probably a safe bet to assume that Apple's annual dividend will hit $20 per share within five years. If you run the numbers, it does not take much organic growth to reach that figure. If Apple averages retiring 25 million shares per year over the next five years, its share count will be reduced to about 775 million shares outstanding. Even if the company did not grow profits over that time frame (highly unlikely), it would still increase earnings per share to $47.74.
If the company decided to pay out a $20 annual dividend at that point, it would only represent 41.89% of profits. Under this no-growth model, the company would be paying out $15 billion in annual dividends relative to a little over $37 billion in profits. In this case, the company would still have $22 billion in annual retained earnings, which would permit Apple's retained capital requirements to double and still be fine.
Right now, Apple is paying out $12.20 per year in dividends. At first blush, it sounds ambitious when I suggest that Apple's dividend will rise to the $20 mark within five years. But it really is conservative calculation, because Apple could meet simply by maintaining a buyback rate of 4.25% of shares outstanding and simultaneously raising the payout ratio to 40%. You don't even have to build core earnings growth into your model to find a way for Apple to get its dividend up to the $20 per share mark. Buybacks to the tune of 4.25% per year and a payout ratio that increases ten percentage points is all it takes for Apple to hit a $20 target within five years, and investors that are willing to tolerate the stock's regular volatility should be rewarded with a very nice dividend growth rate over the next five years.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.