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. Another example is that Apple is apparently holding the cash outside the U.S., and might be 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 example is that 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 for 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 to continue run the company 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). Though 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 or not 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. Consider stylized company X that has: $2 of earnings today; a market projection of present value of cash returned to shareholders of $10; 10 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 when a journalist or academic makes claims that some company could just obviously create enormous value by taking some simple action, the obvious question to them is “Why aren’t you a billionaire?”
(Cross-posted to The Corner)
Really? That’s your question to Matt Yglesias? “Geez, Matt, if you’re so smart why aren’t you distributing your billions in cash to your millions of shareholders?” Your obvious question isn’t exactly very obvious, here, and fundamentally Matt isn’t wondering why Apple is doing what it’s doing, he’s wondering why investors are paying top dollar for Apple stock when, to all intents and purposes, those are nothing but pieces of paper that say “Apple” on them. (And I’d be happy to sell you as many of those as you like, say at $200 apiece?)
Its all very well and good to suggest that the value of Apple stock is, like Google, all in the capital gains; but you don’t have to be a Harvard-educated philosopher to see the base case of this recursive process – eventually somebody at the end has a $380 piece of paper that he can’t sell to anyone else, so what’s the return on investment? Wait an unknown period of time for a completely unknown future dividend, or wait for Apple’s assets to be auctioned off? I don’t think it’s unreasonable to wonder why that’s worth $380 to someone, or to note that this is just another instance where the “stock market” seems to be a situation where people just take money with their left hand and pass it along with their right.
— Chet · Nov 30, 05:00 PM · #
Some key differences between Apple and the burning trash can full of money.
1) When enough shareholders want a cash distribution, they can force Apple to make one. No break up is required.
2) Apple can distribute cash to shareholders either by issuing dividends or by buying back shares at the market price. (Or by doing fancy stuff like spinning off companies that then distribute cash, but same thing).
3) In the short and medium run, shareholders may prefer buybacks or simple retention of cash to distributions, either for tax reasons or because they don’t have any superior use for their money.
4) For some small companies (obviously not Apple), one potential payout is the right to collect a portion of a purchase offer from an acquiring party.
— J Mann · Nov 30, 06:00 PM · #
“he’s wondering why investors are paying top dollar for Apple stock when, to all intents and purposes, those are nothing but pieces of paper that say “Apple” on them.”
What are stocks except piece of paper that say “Company X” on them?
Mike
— MBunge · Nov 30, 09:52 PM · #
My guess is that paying out money as dividends would be read as exactly the same signal as hoarding cash – nothing more interesting to do with the money, therefore you should assume as our existing business matures our growth will slow dramatically.
The agent-principal problem is a real one, though. I’ve often wondered how the world would be different if public corporations had to behave analogously to REITs, and pay out a large majority of their free cash flow as dividends on a regular basis.
Probably Apple would not be a public corporation.
— Noah Millman · Nov 30, 09:56 PM · #
Noah,
That’s my guess as well.
— Jim Manzi · Nov 30, 11:17 PM · #
Traditionally they’re an arrangement by which you pay Company X upfront for a partial ownership in its assets and more importantly, its future profits. In other words, traditionally a stock entitles you to something.
But Apple stock doesn’t seem to entitle you to anything. You can’t own enough to meaningfully vote; they’re not going to sell off their assets; and they’re not sharing profits with the shareholders. Which begs Yglesias’ question – aside from the fact that people are willing to pay $380 for it today and perhaps more (or less) tomorrow, what makes Apple stock worth $380? Manzi took a stab at answering; his answer was “fuck you, is why.” Maybe you can explain it better?
— Chet · Dec 1, 12:56 AM · #
Or another way of putting the question – what would be the difference to an investor, currently, between owning Apple stock and owning a derivative based on Apple stock?
— Chet · Dec 1, 12:59 AM · #
“In other words, traditionally a stock entitles you to something.”
The only thing owning a stock traditionally entitles you to is the right to sell that stock. That’s it. Everything else you’re talking about is contingent on how much stock people own and how the company they own a piece of is run.
I have no idea what Apple should do with its money, whether it should pay a dividend or not. I do know that both you and MattY have the habit of confusing “what your want” with “the way things have to be”. Grown ups really need to be able to tell the difference.
Mike
— MBunge · Dec 1, 04:38 PM · #
Historically that’s absolutely false – the dividends market for shares predates the capital gains market for shares by about a hundred years – but, ok. Why would you own something that the only thing you can do with it is sell it?
And why would “the thing you own only so that you can sell it” be more valuable because it has one company’s name on it instead of another? Why is Apple stock worth more, say, than an Apple cocktail napkin? Because everybody else says so? I know markets are irrational but doesn’t this level of irrationality beg for explanation? It’s fine for you to tell me what a child I am, but for god’s sake brush off the Cheeto dust and try to grapple with the question.
— Chet · Dec 1, 04:52 PM · #
I thought my #s 1 and 3 were the ones most applicable to Apple. For now, a majority of Apple shareholders prefer that Apple amass a hoard of capital, either because they think that Apple can invest it better than they can or for tax reasons. When shareholders holding a majority of the stock want to cash out, they can force Apple to issue dividends.
— J Mann · Dec 1, 05:24 PM · #
“Why is Apple stock worth more, say, than an Apple cocktail napkin? Because everybody else says so?”
Okay, I think this is a level of willfull stupidity that requires someone with professional training to handle it, but here goes.
Apple stock is more valuable than an Apple cocktail napkin in the same way the actual deed to my house is more valuable than a scrap of notebook paper with the phrase “deed to my house” written on it. If you’re incapable of understanding that sort of representational relationship, I’m not qualified to translate and respond to your babbling.
Mike
— MBunge · Dec 1, 05:27 PM · #
“Historically that’s absolutely false – the dividends market for shares predates the capital gains market for shares by about a hundred years”
And the concept of stocks goes back to Ancient Rome while dividends can’t be traced back much further than the 15th Century.
Mike
— MBunge · Dec 1, 05:46 PM · #
Mike … you’re heading towards the bottomless pit, y’know….
I mean, enjoy, and shit. I’ve got popcorn.
— Kieselguhr Kid · Dec 2, 01:04 AM · #
I don’t understand how you’re missing my point so completely, Mike. You should stop, take a deep breath, and read my posts more closely.
Ok, but then you’ve gone completely back on your notion that “the only thing owning a stock traditionally entitles you to is the right to sell that stock.” The deed to your house is a legal instrument that connotes ownership of your house, that’s why its more valuable than a piece of scrap paper that says “house” on it.
If, instead, the “deed to your house” didn’t entitle you to a house, didn’t entitle you to land, and didn’t entitle you to sell anything except the piece of paper itself, what would it be worth? In what sense would it be anything but a piece of paper with your address on it? That’s the position that Apple shareowners are in, with the exception that at some unknown time in the future they might get a dividend of some unknown size. Well, great. That’s like owning a lottery ticket with “Apple” scribbled on it. Which has some non-zero value, yes; but why should its value be larger than another lottery ticket on which someone wrote “Pets.com”?
There’s no need to get testy just because you don’t understand anything about what we’re talking about. I’m sure you can take classes, or something. Try a local community college. Their admissions requirements are typically pretty low.
No, that’s inaccurate. Publicani paid dividends.
— Chet · Dec 2, 02:31 AM · #
The price of a publicly traded stock is always going to be higher than what half of the interested parties, weighted by money, think is reasonable, and lower than what the other half thinks is reasonable.
— Steve Sailer · Dec 2, 02:39 AM · #
Chet writes:
_Ok, but then you’ve gone completely back on your notion that “the only thing owning a stock traditionally entitles you to is the right to sell that stock.” The deed to your house is a legal instrument that connotes ownership of your house, that’s why its more valuable than a piece of scrap paper that says “house” on it.
If, instead, the “deed to your house” didn’t entitle you to a house, didn’t entitle you to land, and didn’t entitle you to sell anything except the piece of paper itself, what would it be worth?_
A better example would be:
1) An instrument that entitled me to 10% of the value of your house in the event that the house is sold. (This is pretty close to a reverse mortgage).
2) That instrument also provides that if the holders of a majority interest in your house agree, they can force you to sell your house.
That’s worth more than a piece of paper reading “Chet’s house.” How much more will depend on investors’ assumptions about your behavior and that of other investors.
Note: Of course, the analogy isn’t perfect, in part because no analogy ever is. Unlike a for-profit corporation, a house has a substantial consumption component.
You could make the analogy better by saying that the instrument also provides that you would pay rent into a bank account associated with the house, and that in the event of a sale or transfer, the instrument holder is entitled to a 10% share in the bank account too. The instrument holder might suspect that the resident was underpaying rent, which serves as a stand in for agency costs, but the rent is theoretically being piled up for a later payout.
Add in voting rights and a liquid market to resell the instrument, and it’s pretty obvious that the instrument will have a value higher than zero, although probably less than its proportionate share of actual ownership.
— J Mann · Dec 2, 03:13 PM · #
Thanks, J Mann. That’s actually a pretty good answer and its very clarifying.
That said, while a piece of the action if Apple does something its pretty clearly never going to do – pay a dividend or sell off all its assets – has some non-zero value, it doesn’t really explain why it would have $380 in value. A one-dollar lottery ticket seems like a better ROI.
— Chet · Dec 2, 08:32 PM · #
A lottery ticket expires after the lottery. Stock is good until bankruptcy or acquisition.
Apple went through a period in the late 90s where they were desperate for cash and ended up taking $150 million in equity capital from Microsoft. It doesn’t surprise me one bit that they prefer to hoard it.
Most tech companies don’t pay dividends because, as Bill Gates has noted, valuing a tech company based on discounted cash flow is foolish. The landscape can change so fast that they may need every bit of that cash in a few years. Look at what’s happened to RIM, or even Motorola.
BTW Apple never paid dividends to Microsoft. Microsoft sold the stock on the open market for a nice profit a few years later. If Microsoft had not sold their shares would be worth over $5 billion. Nice lottery ticket.
— Derek · Dec 3, 03:01 AM · #
Do I have any idea what Apple could profitably do with all those billions in cash?
Not much.
Has there been any evidence over the last dozen years that Apple is smarter about Apple’s interests than I am about Apple’s interests?
Uh … yeah. A lot.
— Steve Sailer · Dec 3, 04:27 AM · #