Photo: Photo by Kevork Djansezian/Getty Images
Some Apple investors have been crying for Apple to initiate a dividend. Recently, those cries only got louder after CEO Tim Cook said he and the Apple c-suite have been in “active discussions” about what to do with company’s mountain of cash.Sure, the company may be well-advised to do something with their cash hoard. After all, it sits on its books generating next to no return in this low interest rate environment. From a shareholder perspective, idle cash is a drag on return on equity.
Companies have a few options when it comes to deploying excess cash. They can invest in new projects, acquire companies, repurchase shares, or pay cash dividends.
Of all of those options paying a dividend is probably the worst idea. Indeed, there are plenty of reasons why initiating a dividend would be ridiculous.
APPLE IS THE MOST IMPORTANT GROWTH COMPANY IN THE WORLD
“Why doesn’t the dividend matter in Apple and matter so much to me in Berkshire Hathaway?” asked Jim Cramer recently. “Pretty simple: earnings momentum.”
Apple is one of the strongest growth stories we may have ever seen in corporate history.
Cash paid out in dividends is cash that can’t go toward investing in growth. And Apple is obviously still growing.
BUT, WOULDN’T A DIVIDEND ATTRACT NEW INVESTORS?
The duty of a company and its board to its shareholders is to boost shareholder wealth.
There’s an idea out there that introducing a dividend could boost the share price as income investors would jump in and equity-income mutual funds would now be allowed to buy the stock for its investors.
But this argument is a bit ridiculous. Any new buying by income investors would be offset by at least some selling by growth investors.
Also, does Apple really want dividend investors to show up to its shareholder meetings? From NYU professor Aswath Damodaran:
When a company that has never paid a regular dividend initiates dividend payments, it attracts new investors, i.e., investors who need or like dividends, into the company. While this “investor expansion” has been used as an argument for regular dividends, I think it should actually be an argument against regular dividends. While some of my best friends are “dividend investors”, I think that they are temperamentally and financially a bad fit for Apple, a immensely profitable company that also operates in a shifting, risky landscape. If Apple initiates a dividend, the demands for increases in those dividends in future years will come and the company will find itself locked into a dividend policy that it may or may not be able to afford.
APPLE CAN AFFORD TO PAY DIVIDENDS AND FINANCE GROWTHThe counterargument to what we have posited so far is that Apple generates so much cash that it would no problem simultaneously paying for dividends and financing internal investments, even over the long run.
Unfortunately, this pro-dividend argument comes with a high degree of confidence that borders on hubris.
Sure, the company may be able to pay a dividend now. But who’s to say that Apple will have the excess cash to easily pay it in the future.
Has everyone already forgotten that it was just around 15 years ago that Apple almost went bankrupt?
Again, like Damodaran said, “[T]he company will find itself locked into a dividend policy that it may or may not be able to afford.”
You see, most investors who invest for dividends want their dividends to be stable. That’s implicit when it comes to most dividend policies. And investors would be seriously inconvenienced if Apple had to reduce or pull the plug on its dividend.
BUT COME ON, IT’S APPLE
But there are plenty of companies out there that have been paying dividends for long periods of time, the Apple bulls will argue. Just look at the long list of companies on S&P’s Dividend Aristocrats. Surely, Apple’s financial position is stronger that that of some of these companies.
OK, for the sake of argument, let’s assume that Apple will have no problem funding its dividend for the rest of eternity.
THE CLIENTELE EFFECT
So, if Apple can and will pay a dividend, what would be the appropriate amount to pay investors?
You run into a problem called the “clientele effect.” According to this idea, people in high tax brackets prefer low dividend payouts, while low tax bracket investors prefer higher payouts. Apple’s executives and directors would now have to waste time on these things rather than other things like developing and launching awesome products.
Perhaps, they’ll go with Bloomberg’s guidance. According to Bloomberg’s analysis of comparable companies, one possible quarterly dividend level for Apple is around $2 per share.
It’s worth noting that BI’s Matt Rosoff did some analysis of comparable companies and found that the introduction of a dividend did nothing for the stock price. If anything, it may have been a drag on the stock price.
OH YEAH, TAXES
The discussion of taxes doesn’t end with what we addressed regarding the “clientele effect.” A much bigger issue is the timing and magnitude of taxes. This is all addressed by something finance academics call the “tax preference theory.”
Dividend investors have to pay dividend taxes when those dividends are paid. And investors can’t exactly say no to dividends. On the other hand capital gains taxes on stock appreciation are recognised only when those capital gains are realised, which is whenever the investor chooses to sell the stock.
Also, taxes on dividends could soon be much higher than long-term capital gains taxes (i.e. the tax imposed on investment gains after it is held for at least a year).
“While both dividends and capital gains are still taxed at the same rate, that will change on January 1, 2013, when the tax rate on dividends reverts back to the ordinary tax rate (which could be 40% or higher),” writes Damodaran.
Furthermore, if an investor never sells the stock, the cost basis on the investment gets reset if an investor bequeaths his shares to his heirs. In other words, it is imaginable that people who inherit Apple shares with a monster capital gain pay no taxes.
Photo: Mario Tama / Getty Images
THE WARREN BUFFETT WAYIf Apple really wants to return wealth to its shareholders in a tax efficient way, the better way is probably to buy back shares rather than a pay dividend.
After all, that’s what Warren Buffett did for Berkshire Hathaway’s shareholders. We wrote all about this last September in an article “Buffett’s Berkshire Buyback Helps Shareholders Dodge Taxes.”
Basically, a buyback gets around the whole issue of investors having to pay a tax right away.
KEEP YOUR DAMN HANDS OFF MY DIVIDENDS
OK, even after all of this, the people who want their regular dividends will continue to argue for their dividends.
Well, according to Franco Modigliani and Merton Miller–top finance theorists–you can have your damn dividends if you want them.
According to their “dividend irrelevance theory,” an investor can effectively create his or her own dividends by…wait for it…selling the stock.
“Miller and Modigliani argued that in perfect capital markets dividends are irrelevant because investors can create their own cash flows by selling portions of the stock,” says Vahan Janjigian PhD of Greenwich Wealth Management.
In M & M’s world there’s no difference between receiving a dividend or just selling shares. From a corporate perspective, there would be no impact to the company’s capital structure.
Unfortunately, M & M’s theory isn’t very realistic.
“However, their proof does not hold when you have imperfect markets, which include things such as transaction costs, taxes, and an inability to sell fractional shares,” says Janjigian.
Nevertheless, it is an idea. Apple just closed at an all time high yesterday. So, unless you’re the absolute worst investor in the world, you can sell shares at a gain. The best part of this is you can effectively create a dividend of any size that you want. Furthermore, you can get that dividend whenever you want.
Still want a dividend? Didn’t think so.
Here’s a quick long-term look at Apple versus the S&P 500 for any of the ungrateful Apple investors.
Photo: Google Finance