Apple's Cash Is Not What It Seems

| About: Apple Inc. (AAPL)

I have to start this article with a disclosure. I actually drafted the article two days before Apple's (NASDAQ:AAPL) dividend announcement. However, I realized that the fundamentals of the article still stand after the announcement and it still presents a viable explanation to how the dividend might affect Apple's stock price. Therefore I decided to post the original draft as it is. Since it was drafted before the announcement it should also be a more objective analysis of the situation.

In a previous article (available here) I had argued that although Apple's valuation is very intriguing, there might be some reasons for that apparent lack of a higher P/E multiple. I singled out that its cash position might not be what it is made out to be, in addition to some cracks in its growth mechanics.

In this article I will go into more detail about what to make about the company's huge cash pile and how to integrate it into the valuation of the company.

In many op-eds around the financial media, it is mentioned that the correct way to value Apple is to subtract that cash balance from the market cap and calculate the earnings multiple afterwards. Of course, the company becomes even more of a good value when you do that. However a more careful analysis of the valuation metrics reveals that backing out the cash position might not be the correct way to go for small investors.

The value that you get when you subtract the cash position is something called the Enterprise Value (EV). In reality, enterprise value is found by adding back the net financial debt of the company and then subtracting the cash and short-term investments. In the case of Apple, since there is no financial debt the equation simplifies to just subtracting the cash. Enterprise value is the value of the earnings power of the company, but it disregards the assets accumulated on the balance sheet of the company. In many respects, it is true that enterprise value is the correct variable to use if your sole intention is to find the value of the future earnings power of the company.

Enterprise value is a term that is mostly found in the world of corporate finance and M&A. The reason it is more commonly used in those branches of finance is that the investments made in that arena are usually for either controlling or significant minority stakes. In those cases, any unneeded cash on the balance sheet is disregarded from the valuation. The reason is that when you gain control you can immediately choose to distribute that cash or even take on more debt. You can effectively choose the capital structure that best suits your risk/return expectations. What matters to you is the earnings power of the company, and hence the use of enterprise value rather than market cap. You can lever up the company to increase risk but also returns on equity. Or you can choose to keep the cash on the balance sheet to make the company virtually risk-free, which would decrease your return on equity.

When you are a small stake owner, however, things are different. When you buy the shares of a company, you are effectively making the decision that the company will use that capital more effectively than yourself in generating returns. However, if the company chooses to keep a lot of cash on the balance sheet that is not good news to you. It means that the company is taking your money and just putting it in low yielding bonds, which you could have done yourself. You are effectively paying the management dearly for something you could have done yourself.

Another way to analyze it, is through the P/E ratio. Basically when you buy stock in a company you are paying P, to get E annually. You are also assuming that E will somehow grow incrementally. After integrating the earnings growth, you are basically making the decision that the company will generate more E, than the interest you would have earned if you were the invest P in a fixed income instrument with the same risk.

Before we move on to what the effect of this is on the stock price, there is one more variable to consider and that is risk. Usually keeping a certain amount of cash on the balance sheet decreases the risk. That decrease in risk pushes the P/E ratio up (decreases your earnings yield) because it wouldn't be fair if you got the same yield as a riskier investment. However, if the cash on the balance sheet of the company exceeds levels that would no longer decrease the risk, then the effect on the P/E disappears as well. The last case is precisely the situation Apple is in, and precisely why it doesn't make sense to back out the cash position in valuing the company.

Lastly, let's analyze how these valuation techniques we have overviewed apply to Apple. In Apple's case the risk to the company from any capital shortage is virtually zero. The only risk (uncertainty) in determining the P/E ratio is the fluctuations in earnings growth. Basically the decision to distribute the cash or keep it on the balance sheet has no effect on any of the variables in Apple's case. It doesn't change P, E or the earnings growth. The only counterargument might be that the extra cash can enable Apple to make acquisitions that would affect earnings growth. However, even the company has admitted that the level of the cash is beyond what is needed for even the most sizable acquisitions.

From the analysis above I can deduce that the dividend decision will have no effect on how the small investors value the company. In my opinion, virtually all of the movements in the stock price is due to movements in the Nasdaq (NASDAQ:QQQ) and whether the P/E ratio is still too low even before backing out the cash. I would suggest that the dividend announcement will not protect Apple from a change in market trends. Also if the market continues to trade higher, Apple will probably keep rising.

One thing that has been brought up is whether certain funds that are required to invest in securities with a dividend will be able to invest in Apple and push up the price. In that regard, I can't make an informed decision since I am not sure about the significance of those investors given the company's size. I would encourage any SA readers with some good stats on that respect to comment below. However, I can suggest that the tech market's trend and Apple's earnings growth expectations still accounts for the majority of the moves in Apple's stock. I wouldn't be surprised if the dividend announcement proves to be a non-event, or a change in the upward trend of the market completely negates the effects of the dividend.

Disclosure: I have no positions in any stocks mentioned, but may initiate a short position in AAPL over the next 72 hours.

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