A Massive Apple Inc. (AAPL) Buyback

What should Apple Inc. (NASDAQ:AAPL) do with all of its cash? This question has been heavily debated ever since the stock began an epic nosedive from $700 per share to around $430 per share over just a few months. Apple has $137 billion in cash and investments, which represents about 34% of the company’s total market capitalization. It’s clear that Apple can’t possibly reinvest all of this cash into its business, and going on an acquisition spree has almost never turned out well for other tech companies. This leaves three options: raising the dividend significantly, a one-time special dividend, or a massive share buyback program.

Apple Inc AAPL

When buybacks make sense

Share buybacks are not always a good idea. When a company’s stock is overvalued buybacks are a tremendous waste of money. Too many times buybacks have been used to artificially prop up the stock price, with disastrous consequences in terms of shareholder value. But when a company’s stock is undervalued buying back shares is a far better option than paying a dividend. Warren Buffett says it best:

Charlie and I favor repurchases when two conditions are met: first, a company has ample funds to take care of the operational and liquidity needs of its business; second, its stock is selling at a material discount to the company’s intrinsic business value, conservatively calculated.

We have witnessed many bouts of repurchasing that failed our second test. Sometimes, of course, infractions—even serious ones—are innocent; many CEOs never stop believing their stock is cheap. In other instances, a less benign conclusion seems warranted. It doesn’t suffice to say that repurchases are being made to offset the dilution from stock issuances or simply because a company has excess cash. Continuing shareholders are hurt unless shares are purchased below intrinsic value.

I wrote about Apple Inc. (NASDAQ:AAPL) recently in an article titled “Getting Real About Apple.” In that article I showed that even under pessimistic growth scenarios Apple is worth more than the $430 per share it’s currently trading for. This means that a share buyback program would greatly benefit shareholders, since shares can be bought for far less than they’re really worth. But exactly how much shareholder value could be reaped from such a program?

A massive buyback

Like I’ve said, Apple Inc. (NASDAQ:AAPL) has $137 billion in cash. On top of this the company generated $41 billion in free cash flow in fiscal 2012. For the purpose of this discussion I’ll assume that the current fair value of Apple is $650 per share, which is the low-end of my slow-growth scenario from my previous Apple article.

In a hypothetical buyback program let’s say that Apple Inc. (NASDAQ:AAPL) spends $1 billion per week on share buybacks over the next two years. This would result in a total of $104 billion in buybacks, easily covered by the current cash balance. As long as the price which the company pays is below the fair value then there is a net benefit for shareholders. Below is a table of the number of shares which would be bought back over this two-year period for various average share buyback prices. The current diluted share count is 947 million.

Avg. buyback price Number of shares repurchased
$430 241.86 million
$460 226.09 million
$500 208 million
$550 189.09 million
$600 173.33 million
$650 160 million

If Apple Inc. (NASDAQ:AAPL) were able to repurchase all $104 billion of shares at the current market price the share count would be reduced by 241.86 million, or 25.5%. Of course, the introduction of this program would most likely cause shares to rebound to some degree, so I’ll assume that $550 is the average buyback price. This is close to the average between the all-time high of $700 per share and the current price of $430 per share. In this case the share count would be reduced by about 20% by the buyback program.

To value Apple Inc. (NASDAQ:AAPL) post-buyback I’ll use the same methodology from my previous article – a simple discounted cash flow calculation. My slow-growth scenario assumed 6% annual growth for 10 years and 3% growth after that, so I’ll use the same assumptions here. Now, over two years the $104 billion spent on buybacks would partially be replenished by the free cash flow. Some of this will go to dividends, so I’ll be conservative and say that $60 billion is added to the balance sheet in cash over the next two years. This would put the total cash level at $93 billion at the end of the two year period. With the newly reduced share count this is about $122 per share, slightly less than the $144 per share of cash today.

The real value is added from profits being split over fewer shares. Since the share count is reduced by 20% the FCF per share is increased by that same amount. Doing the same calculation as in the previous article the new fair value of a share of Apple Inc. (NASDAQ:AAPL) after this two-year buyback program is $755 per share. This is a 16% increase in the fair value and a full 75% higher than the current share price.

The bottom line

While share buybacks are often claimed to be a good idea it’s rare that the effect on the fair value is even talked about. In the case of Apple a share buyback program can greatly increase the fair value of the stock as long as the company doesn’t overpay. Obviously the numbers change if you believe that Apple Inc. (NASDAQ:AAPL) is worth more or less currently than I’ve assumed here, and this calculation is rough to begin with. But I think it’s clear that a buyback is the best option for Apple. Dividends are all well and good, but they don’t add to shareholder value like buying back undervalued shares. A massive Apple buyback is the best use of Apple’s cash.

The article A Massive Apple Buyback originally appeared on Fool.com and is written by Timothy Green.

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