The private equity industry long ago figured out a secret about stock market investors. They have since used it to make huge profits over the years. Read on and I'll reveal the secret and how Apple can use it to make its shareholders a 100% return.
The secret
Stock market investors regularly only talk in multiples. They'll say things like Apple (AAPL -1.22%) looks cheap at 13 times expected earnings, McDonald's is a "happy meal" at a P/E of 15, or Rite Aid is cheap at a price-to-sales ratio of 0.22 compared to competitors at 0.7.
That is, most investors value companies based on income and sales multiples and never consider a company's balance sheet.
This is actually a global trait. A Harvard Business Review study found that out of all the factors for buying a stock, analysts around the world all listed balance sheet strength as being of very low importance. Analysts called out projected industry growth and quality of top management as factors they consider to be very important.
Private equity has realized they can use debt to enrich themselves and then sell weak companies back to the investing public who are only interested in the earnings multiple and not the balance sheet.
How private equity profits from the secret
A simplified version of how it works is a private equity firm buys a company using only debt. It adds the debt to the company's balance sheet, cuts costs to increase profitability, and takes out as much cash from the company as it can by issuing dividends and adding debt to the company. The firm will then sell the company to the market through an initial public offering at the same value that it bought it or hopefully higher.
The key is, investors are willing to pay the same earnings multiple as before for the "newly improved" company despite the fact that it has a weak balance sheet loaded with debt.
The massive profit comes from the dividends the private equity firm paid itself as well as the fact that it put up no cash of its own to buy the company. So all the gains from the sale flow to the private equity investors and public market investors are buying a company loaded with debt.
While this is a simplified version of events it's basically what happens. Relatively recent examples would be Dunkin Brands, Hilton Worldwide, and Quintiles.
How other companies have used the secret
While I would not advocate loading a company with debt, companies can intelligently take on some debt and pay out large special dividends to take advantage of this.
Choice Hotels International (CHH -0.61%) did this recently. In June 2012, the stock was trading near $36, the company announced it would pay a $10.41 special dividend for onetime yield of nearly 30%. The dividend was funded through a combination of cash as well as debt. When the dividend was paid on August 24, the stock dropped by the amount of the dividend yet nothing was different about earnings potential of the company. It was still slowly improving, so investors bid the stock back up to its previous value at 18 times earnings over the next six months.
Overall investors earned a return of 30% not including the company's regular dividend.
20% gain for Apple shareholders
Apple is trading at 13 times earnings and is in the unique position of having a $100 billion excess cash hoard. If the company were to pay out its excess cash as a special dividend and then the stock returned to its 13 times multiple, investors would earn 20%.
50% gain for Apple shareholders
If Tim Cook were to follow the private equity method of stripping all the cash out of the company and adding as much debt as he could, the gain could be as high as 50%.
Let's say Apple added another $125 billion of debt on top of its current $17 billion in debt and was willing to pay out $125 of its current $150 billion in cash. Apple, then, could pay out a $250 billion special dividend. Its stock would drop by the amount of the dividend and would then be trading at just six times earnings. As investors bid up the stock back to 13 times earnings, investors who just held the stock would be up 50%.
100% gain for Apple shareholders
If an investor, however, reinvested the dividend at the lower price and shares rose back to 13 times earnings, they would earn a 100% return on their shares.
Foolish bottom line
I would never advocate for management to do something to structurally weaken a company, so I don't think they should take on debt to pay a dividend. Yet I do believe Apple should pay out its excess cash as a dividend.
As I've written before, the secret to Apple's success has always been understanding customers' needs better than any other company, empowering small groups of people to do great work, obsessively pursuing perfection in design, and maintaining a singular focus that precludes all distractions. None of these require $150 billion, and the fact that CEO Tim Cook has spent so much time talking about it shows that the cash is a distraction.
The cash hoard should be a complete nonissue for Apple. Distribute excess cash to shareholders. Don't favor exiting shareholders over loyal long-term holders by buying back stock. Focus on what Apple does best: making great products.
