No Dividend, No Worries

Karl Smith made a funny point in response to my post about Apple’s (AAPL) 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 (BRK.A) 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?