The Corner

‘Nobody Ever Went Broke with Money in the Bank’

That’s something that one of the smartest venture capitalists I ever knew once told me.

Matt Yglesias and Karl Smith find the fact that Apple is holding a huge cash hoard instead of paying dividends to shareholders to be pretty ridiculous. Felix Salmon finds Yglesias’s argument “trivially wrong.” All three are smart observers with interesting things to say, but I don’t think any of them presents this situation very well.

Yglesias says that this cash hoarding has caused Apple’s declining price/earnings (P/E) ratio:

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.

I’ve started and run a pretty successful enterprise software company, and I generally held a lot of cash on the balance sheet. From the perspective of shareholders, there can be many good reasons for this. First, do you know when cash-on-hand is most important? When nobody else has any. You can buy up the best talent, patents, and assets when they are cheap; you can make big technology investments when they are cheaper; you can make big marketing pushes for the resulting new products when competition for customer mindshare is lower, and so on. When times are good (or at least not catastrophic) it seems like you could always get your hands on cash when you needed it, but that’s least true when you most want it. Cash is the option to act decisively at the moment when this can create large advantages for the company.

Apple is apparently holding the cash outside the U.S., so another possibility is that they’re playing for time before repatriating it because they think corporate tax rates might come down. They might be playing any one of a million tax angles. Another possibility: A massive cash pile can discourage potential competitors from entering important markets, because they know you can retaliate by either crushing their foray into your territory or by going after their cash cows. The U.S. will hopefully never launch its nuclear weapons, but we use them every day. 

There are also not-so-good-for-shareholders reasons Apple might be doing it. There is an armchair-psychology theory that because Jobs went through so many close calls in business, he had an irrational desire for cash on hand. That is at least plausible. But even if so, it’s not as simple as the shareholders just ordering Jobs to disburse the cash. If you believe that Jobs had this irrational desire, but part of the package required to get Jobs was to allow this kind of cash build-up, and that he increased shareholder value enough versus the next-best-alternative CEO to more than offset the impact of holding this much cash, then it still might be rational for shareholders to let him do it. In my experience, exactly this kind of dynamic happens in the real world all the time.

More generally, sometimes a very large cash balance is an indicator that there is a principal-agent problem between shareholders (who want to maximize risk-adjusted returns on a portfolio of assets that includes this stock) and management (who want an operational cushion). But sometimes a large cash balance is an indicator of a disciplined management team that refuses to make poor investments in acquisitions or fanciful projects. 

In short, there are tons of reasons — some good and some bad — why Apple might be holding this much cash. Apple’s P/E is being affected by some combination of their growing cash pile, changing overall market conditions, the death of Steve Jobs, projections of market saturation, beliefs about future Apple investment plans, competitive behavior, and many other factors. I don’t know whether Apple’s cash balance is too high or not; but based on this post, neither does Yglesias.

Salmon says of Yglesias’s argument:

This is trivially wrong. If Apple’s cash pile is growing, that will increase its p/e ratio, rather than decrease it.

In simplified terms, Salmon’s argument is the following.#more# Consider stylized company X that has: $2 of earnings today; a market projection of present value of cash returned to shareholders of $10; ten shares of stock outstanding; and no net cash on hand. In theory, the company should be worth its present value of cash flows, or $10. This would produce a share price of $10 / 10 shares = $1 per share. This implies a P/E of $1 / $2 = 0.5. If nothing else changes except the company has $2 of cash on its balance sheet, then in theory the company should be worth $10 + $2 = $12. This would produce a share price of $12 / 10 = $1.2. This implies a P/E of $1.2 / $2 = 0.6. So, Salmon argues, Apple piling up cash should increase P/E.

But, what this ignores is that the fact that Apple management has decided to retain the cash can rationally influence investor beliefs about the present value of future cash returned to shareholders in relation to current earnings. Yglesias illustrates the size and rate of growth of Apple’s cash balance by citing a quarter-to-quarter change, but his argument refers to a chart of Apple’s P/E over nine quarters. On this kind of timescale, the fact that management has decided to retain this much cash — rather than either invest it in the business, or pay dividends, or buy back shares — could be a signal to outside investors that management believes growth prospects are lower than previously believed, or that management has become irresponsible in its use of cash, or any other of many possible positive or negative signals. Different investors almost certainly read it different ways. Yglesias is not “trivially wrong.” He might even be right. I just don’t think either he or Salmon knows.

Smith is even more scathing than Yglesias about the point that Apple isn’t using the cash to pay dividends to shareholders:

I have a theory.

On the one hand you can buy Apple stock for $375 a share and pay $7 to ScottTrade. On the other hand I also have a trash can in which you can deposit your $375, pay me $5 and I will set it on fire for you.

Clearly, I am offering the better deal as in both cases you have approximately zero probability of getting your money back and I am willing to burn it for $5 whereas you have to pay ScottTrade $7.

Now that’s not quite true. Apple’s stock price is sustained by the fact that if it goes low enough someone will buy the whole company and liquidate it. However, current investors shouldn’t be under any delusions that Apple has any plans whatsoever to provide them with a return on their investment.

I think that Smith’s point is that because Apple has not paid dividends, therefore I never get paid back real cash in return for the cash I pay for a share of Apple stock, and the only thing I can do with it is to sell it on to some greater fool. The only exception is if Apple gets to a sufficiently low value that owners band together and sell off the land, buildings, inventories, desks, patents, and so on in an auction, and then divide up the proceeds. 

Assuming that’s what he means, I don’t think it makes a lot of sense. 

First, big tech companies often don’t pay dividends for a long time, until they do. Sometimes, these dividends are massive and continuing. Second, if there are continuing growth prospects for Apple that require cash (sometimes in ways that aren’t obvious, as per the first part of this post), then it makes sense for me as a shareholder to not want dividends for some time. The present value of the anticipated dividend stream is higher by getting more money later. If, at a future date, I have a desire for liquidity, I can sell my share of stock to another investor at that time. That investor may go through the same cycle, and the person he sells to may go through the same cycle, and so on. As long as the profit growth prospects are real, nobody has been a fool. Ultimately, the purpose of equity is to be converted into cash (or more precisely, consumption); but for a company like Apple, this can take a long time, and not every investor wants to go along for the whole ride. Third, the “exception” of shareholders banding together is not an exception, but something that often happens to companies well before their stock price reaches liquidation value. This is called the market for corporate control.

I don’t believe in anything approaching purely efficient markets. But any time a journalist or academic claims that some company could create enormous value by taking some simple action, the obvious question to them is, “Why aren’t you a billionaire?”

Jim Manzi is CEO of Applied Predictive Technologies (APT), an applied artificial intelligence software company.


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