To buy back stock or not to buy back stock? That is the question for Apple.

It's a question that's tripped up many a corporate executive as companies often rush to trumpet their success during good times by buying back stock even if the timing is awful and the stock is woefully overvalued.

In a recent blog post, NYU finance professor and valuation expert Aswath Damodaran took on the topic and illuminated the fact that if markets are rational and have valued a debt-free company's cash properly, there shouldn't be a share price impact from a buyback (you can get the wonky details here).

In addition, he outlined three factors that come together to determine what impact a buyback will have on the company's shares:

  1. Market's valuation of cash. Just because a company has a certain amount of cash on its balance sheet doesn't mean that the market is giving it full credit for that balance. For a company with a history of bad acquisitions, the market may value the cash at less than face value. On the other hand, investors might be willing to value cash at more than its face value if it's on the balance sheet of, say, Berkshire Hathaway (NYSE: BRK-A)(NYSE: BRK-B),  where they believe it will end up earning significant returns.
  2. Leverage. In discounted cash flow valuations, the valuation depends a great deal on the company's cost of capital -- the combined cost to get debt and equity financing. When a company without much debt uses cheap debt to finance a buyback, it can bring down its cost of capital, which raises the company's overall value. However, a company that already has a lot of debt that uses debt to fund a buyback may actually increase its overall cost of capital and bring down its overall value.
  3. Market signaling. Damodaran referred to this as "value of operating assets," but I think this title may be a bit better suited for his description. In essence, when a company buys back stock, the market will make up its mind as to why the company is doing it. If the consensus is that things are going really well for the company and therefore it can afford to spend money on buybacks, the market may increase its valuation for the company. However, if investors instead think the company is using its cash because growth opportunities have dried up and it doesn't have a better use for it, then the market may bump down its valuation for the company.

On to Apple
Interestingly, Damodaran then leads the discussion to Apple (Nasdaq: AAPL) and his view that the company should not use its cash hoard for buybacks. He points out that the company has great returns on operating assets -- and therefore, theoretical high-return possibilities for cash -- and there is a market perception that there is more growth ahead for Apple. Getting rid of the cash would not allow the company to put the cash to use and earn big returns, and it could signal to the market that it's running out of growth ideas.

In a previous blog post, he had made a case for the company not using the cash pile for a special dividend or a buyback, noting: "Do you trust Apple's managers with your cash?"

It's actually an interesting question because I really don't know the answer. Over the past decade, Apple has had only one year (2002) where it didn't generate free cash flow -- in other words, it has very rarely needed any extra cash from its balance sheet for new projects and the like. Meanwhile, the company has spent less than $1 billion on acquisitions. So really I don't think we have much to go on when trying to figure out whether they'll squander that giant war chest.

Creative geniuses? Sure. Incredible innovators? I'm on board with that. Capital allocation experts? I'm not convinced.

What's your take on Apple's cash? Share your thoughts in the comments section below.

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