Why Apple Should Not Pay a Dividend

OK, I've had enough.

It seems as if every day a pundit claims that Apple (Nasdaq: AAPL  ) and Google are hurting shareholders by not paying a dividend, or that Microsoft (Nasdaq: MSFT  ) and Cisco (Nasdaq: CSCO  ) aren't paying enough.

I've beaten around the bush on this issue before, but it's time for me to explain -- in no uncertain terms -- why this is not so.

The dividend illusion
Let's say Tim Cook listened to the pundits and paid a dividend of $10 per share. What would happen to the share price of Apple, all else being equal, when the stock went ex-dividend?

The share price would fall $10.

So let's see -- you've received $10 in dividends and your share price fell by $10. On the whole -- not taking into account the double taxation of dividends -- you're back where you started. No more, no less.

Now, I'm sure some of you are skeptical that Apple's share price would really fall by $10. But think about what that would mean if it didn't: You could buy the stock just before the ex-dividend date, sell it ex-dividend, and pocket the dividend with no risk. You'd be getting something for nothing.

If this worked, everyone would do it. And there's no reason why it should: As a shareholder, it's your cash regardless of whether it's given to you in higher shareholders' equity per share (which increases the share price $1 for $1) or a cash dividend. You can always sell shares to create a dividend in whatever amount you wish. As long as management isn't lighting cash on fire (literally or metaphorically), you're free to access it either way.

How I learned to stop worrying and love the cash hoard
The fact that stock prices fall ex-dividend is predicted by a watershed, and extremely counter-intuitive, theory in finance that has tremendous implications for our cash hoarders.

In 1985, Franco Modigliani was awarded the Nobel Prize in economics for what is now commonly known as the Modigliani-Miller capital structure irrelevance theorem. Try whipping that out on a first date … preferably with someone you don't care to marry.

The easiest way to explain it (for the three of you still listening) is with homebuying. It's a bit of a simplification, but it will do for our purposes.

Say you want to buy a house. You have three financing options:

  1. Equity financing: Pay in cash like grandpa did. The downside is that it's your money at risk, not the bank's, and appreciation in your home price isn't guaranteed. Therefore, you're going to require a high return on it to compensate for risk, making it costly.
  2. Debt financing: Mortgage debt is usually pretty cheap, because the bank is contractually guaranteed a return or it gets the house.
  3. Some combination of the two.

What's the least costly way to finance the house? In fancy-pants finance language, that's asking which way minimizes the house's weighted average cost of capital, or WACC.

According to Modigliani and Miller, there's no wrong answer in a perfect and efficient capital market (we'll get to that). Your choice is irrelevant.

The more cheap debt you use, the more at risk you'll be of defaulting, and therefore you'll require a higher return on whatever little equity you have. Conversely, the more "costly" equity you use, the less chance you'll have of losing it in a default, and therefore you'll require a lower return on said equity.

The end result is that the house's cost of capital is the same no matter how you finance it. Any advantage in using more debt gets nullified by a rising cost of equity.

Therefore, you should focus on getting the right house at the right price -- making a good investment, in other words -- and not the financing.

And that's the essence of Modigliani-Miller: What creates or destroys value is investment decisions (like iPad development), and not how those decisions are financed.

So what does this have to do with dividends or tech-company cash hoards? Letting the cash "hoard" grow pushes a capital structure toward equity. (In Apple's case, it's even less of a non-event since it's already 100% equity.) According to M&M, there is no harm in this as long as the cash is invested in something with returns commensurate with the risk. And since tech-company cash is basically sitting in T-bills, this is the case.

Now, I agree that in the real world, companies look at taxes, transaction costs, and other factors as they come up with an optimal capital structure. Such tweaking may allow a company to benefit from such frictions. But you certainly won't be able to retire on it.

And that's the basic lesson of Modigliani-Miller for investors: What's going to create or destroy value over the long run is how well a company invests, and not its capital structure or dividend policy. A bad company can't save itself by messing with capital structure or dividends, and poor dividends won't sink a good company. At the end of the day, it's about wise investing, baby. Just look at the success of dividend-less Berkshire Hathaway (NYSE: BRK-B  ) .

Therefore, Apple should be applauded, and not shunned, for neglecting dividends and keeping a apathetic capital structure (100% equity). In a decade when so many corporations tried to create value through financial wizardry, Apple kept its eye on what matters most: investing in profitable ventures like the iPhone, iPad, and iPod.

Why dividend stocks outperform
Some of you might be saying, "Well, won't having tons of cash make it easier for a company to waste my money? Just look at Microsoft buying Skype. Or Microsoft bidding on Yahoo! Or anything Microsoft has done in the past 10 years. What about buying back shares at wild valuations?"

Sure, but if you don't trust a company's management, why would you own the stock in the first place? You have no business partnering with a management that you think wastes your money, dividend or no dividend.

Besides, managements don't need cash to steal from you. They can waste money issuing stock or debt: look at Kraft's Cadbury acquisition. If capital allocation is the problem, the solution is changing the regime and culture of the organization -- not dividend policy as a prophylactic.

As for why dividend payers beat the Dow Jones Industrial Average (INDEX: ^DJI), as Jeremy Siegel and other dividend pushers attest, remember that correlation is not causation. I'd wager that once again it's investment policy -- and not the dividend policy itself -- that causes dividend-paying stocks to outperform. Having the surplus free cash flow to pay dividends is often the sign of a company that makes wise investment choices. That's why Vanguard Dividend Appreciation (NYSE: VIG  ) is my largest holding.

So the bottom line is that if you're comfortable with how Apple, Google, Cisco, and Microsoft invest money, and you believe in their managements, and think their valuations are reasonable, don't let the pundits scare you with dividend policy.

Though with double taxation, if I were Tim Cook, I’d stick with no dividend.

To keep updated on all things Apple, be sure to add the company to our free My Watchlist service, which delivers up-to-date news and analysis on the company:

  • Add Apple to My Watchlist.

Fool contributor Chris Baines is a value investor. Follow him on Twitter, where he goes by @askchrisbainesChris' stock picks and pans have outperformed 86% of players on CAPS. He owns shares of Berkshire Hathaway and Vanguard Dividend Appreciation. The Motley Fool owns shares of Berkshire Hathaway, Yahoo!, Microsoft, Apple, Cisco Systems, and Google and has created a bull call spread position on Cisco Systems. Motley Fool newsletter services have recommended buying shares of Cisco Systems, Microsoft, Google, Berkshire Hathaway, Yahoo!, and Apple and creating bull call spread positions in Microsoft and Apple. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


Read/Post Comments (10) | Recommend This Article (14)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On September 26, 2011, at 9:50 PM, dstb wrote:

    A stock does not always fall by the amount of the dividend. Maybe it should but it's just not always the case. And even if it does, that drop is usually quickly made up for a stock that pays a regular and reliable dividend. One time dividends are a different story.

    Selling a stock to create your own dividend is fine if the stock is going up in value. In times when it is not, a dividend is all you have. I'll never be convinced that a company should hoard excess cash rather than paying it out to shareholders in one form or another. The key word here being "excess." Apple has a lot of excess cash.

  • Report this Comment On September 26, 2011, at 10:02 PM, cbaines2 wrote:

    Hey dstb, thanks for taking the time to write a thoughtful comment.

    "Selling a stock to create your own dividend is fine if the stock is going up in value. In times when it is not, a dividend is all you have."

    The idea here is that a dividend paying stock would be even higher in price if it weren't for the dividend. The dividend pushes down the price every time it's paid, but 99% of the time you don't really notice it.

    It you think I'm making this stuff up Google "bird in the hand fallacy."

    Thanks again,

    Chris Baines

  • Report this Comment On September 26, 2011, at 10:05 PM, sidste wrote:

    What is your view on stock buy-backs?

    Thanks

  • Report this Comment On September 26, 2011, at 10:16 PM, cbaines2 wrote:

    sidste,

    Buybacks was an issue I meant to address more in the piece, but I wanted to keep the size manageable.

    In general, if they're done at a fair price, they don't do much. They're like dividends in that case.

    If they're done at a great price (the stock is undervalued), then it can add value. Sometimes companies do buybacks to signal precisely this.

    And, finally, if they're done at a bad price (stock is overvalued), then it's a bad way to spend money. It destroys value.

    The irony with Apple, since it's 100% equity, is that doing a buyback at a fair price is even less of a non-event. This is because they'd be using cash - which is equity - to purchase equity in the form of stock. An equity-for-equity transaction is a wash. Unless, of course, they were able to purchase the stock from a sucker at a great price.

    Thanks,

    Chris Baines

  • Report this Comment On September 26, 2011, at 10:46 PM, rlhoman wrote:

    I have to strongly disagree that Apple can do a better job spending my money (i.e the dividend) than I can. History is full of examples of companies wasting large piles of money. Whether it's HP buying Compaq or Time Warner buying AOL, we see CEO's using company money to pump up their own ego rather than doing what's best for the stockholders. I'm fairly sure I am not going to splurge with my money, I am quite uncomfortable with assuming Apple is not.

  • Report this Comment On September 27, 2011, at 3:31 AM, SisyphusRocks wrote:

    Here's the problem with this argument - Apple's money that isn't invested in Apple's organic growth is not earning very much. Their cash earns a lot less than Microsoft or Cisco or IBM gets for their excess cash.

    Frankly, I would much rather have a dividend with a lower stock price that results from the cash payment so that I could reinvest those funds in something paying higher than T-bill rates - like purchasing more APPL.

    If Apple could put its cash hoard to use for organic growth or even reasonable acquisitions, that might be worthwhile. But in the meantime, if I want to own a piece of Apple's amazing innovation and growth, I am stuck with about a quarter of my investment basically earning T-bill rates. That's holding back shareholder value.

    And there is empirical data to support the argument that large cash balances hurt the rate of growth of a stock's price (though they limit a stock's downside, as well).

  • Report this Comment On September 27, 2011, at 7:43 AM, 3fr62ccd wrote:

    I like to own Apple stock but without a dividend I am forced to sell a few shares now and then as the stock goes up to generate some income. This triggers capital gains taxes. Also, should the stock go down, at least I got some dividends to show for.

  • Report this Comment On September 27, 2011, at 10:24 AM, lojikfool wrote:

    Hi Chris, good of you to entertain the myopic views you responded to so civilly. My question is that theres billions of dollars of investment funds that will not or cannot invest in non dividend paying stocks, they are being foolish but I think the pros outweigh the cons in this case. We might get a similar pop if aapl joined the dow. Why do you think aapl is so cheap.

  • Report this Comment On October 05, 2011, at 10:09 AM, toneill69 wrote:

    Dividend is the shareholders share on the investment. For a company to sit on hoards of cash and give their CEO a package potentially worth a billion is downright unfair.Apple let us have our share and if we want to we can buy more stock. The problem with billions hanging around a company, more than they need will eventually lead to it being spent many times on their own compensation. The Greed factor takes over.If there ever was a time that Apple should pay a dividend it is now- if not now then when -perhaps never- if that is the case let me know - so i can bail out. BTW total nonsense that a $10 dividend would hit the value by $10.VALUE =BENEFITS remember

    Apple Board wake up - you represent the shareholders - or do you?

  • Report this Comment On October 13, 2011, at 1:47 AM, paulftw wrote:

    mayve i am the fool

    would i go to work for a company that did not pay me?

    I do not invest in a company that will not pay dividends....

    seems that most companies in the computer industry give their workers shares of stock when first going to work for the company ...

    now if i end up buying those shares of stock

    what do i get ?

    no gaurantee .......if i buy a dividend stock

    than i have a chance of getting some of my return

    and am paid to leave my money there .....

    It is good for companies to reinvest capital to buy other companies whether good or bad

    seems you can get some good workers by just buying the company with no interviews etc

    but

    as for me ....I do not buy companies that do not pay dividends .......

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