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Source: Apple.com.

Apple (NASDAQ:AAPL) is the largest publicly traded company in the world, with a market cap of more than $720 billion dollars. It had more than $190 billion in cash and equivalents on its balance sheet last quarter, and that number will almost certainly be greater when it reports earnings later this week.

Apple's free cash flow, or FCF, continues to grow faster than its dividend payments and funds used for share repurchases combined. What the company should do with this excess cash has long been a point of contention among Apple investors.

A dividend was reinstituted in August 2012, and has been raised every year since. The Board has authorized an expansion to the company's buyback program where, according to an Apple press release, it "plans to utilize a cumulative total of $200 billion of cash by the end of March 2017."

Capital allocation is one of the most important jobs for a CEO and management team, and perhaps the most important for a company of Apple's size and financial strength. Understanding how dividends and buybacks play off each other is important to understanding Apple's future success. 

The all-growth years
When a company feels that it can achieve superior returns by reinvesting earnings into the business, it should do so. From 2009-2012, Apple was achieving EPS growth from a low of 59.50% to a high of 82.71% year over year. When it can achieve internal returns like this, it almost certainly outstrips the returns that could be achieved had the cash been returned to shareholders for them to deploy on their own.

By reinvesting earnings successfully into the business, a company gives its shareholders a tax-deferred path to a greater earnings claim in the future. During these years, reinvesting everything back into the business was the right move for Apple.

The buyback and dividend hybrid years
Apple began paying a small (in yield terms) dividend in 2012. Its cash hoard became so large that it could reinvest into every internal project that it wanted to, and make any strategic acquisition necessary -- and still have an abundance of excess cash. At this point, it made sense to begin to deploy some of this excess cash that was now returning close to 0% to shareholders to let them do with it as they pleased. 

Apple also began a share buyback plan, which has now, as previously mentioned, reached an authorization level of $200 billion. When a company buys back its own stock, it's essentially acting as an investor in its own company. The goal is to buy the stock when you think it's being undervalued by the market. When a company buys back stock, it usually "retires" it so that all existing shareholders automatically now control a larger percentage of the overall pie.

Imagine four friends who own a pizzeria together in equal shares. Three of them have decided to stay in for the long haul, and have put a fair value on the whole operation at $1 million, but one is getting skittish and wants to leave. If the three friends buy the fourth one out, the remaining three will each own a third of the business.

If the fourth friend tries to sell his piece for $300,000, the others should hold out, as this would value the whole pizzeria at $1.2 million, which is above their fair-value estimate. When he comes back with a counter offer for $200,000, the friends should jump on it, as they are each buying more of the company for a discount to their estimated fair value. The scale is immensely different in a publicly traded company -- especially one the size of Apple -- but the underlying logic is the same.

Apple has reduced its share count from more than 6.6 billion in 2012 to 5.93 billion on a TTM basis. As long as management purchased these shares for less than their intrinsic value -- and I'm a firm believer that they have -- they have increased the value of each remaining shareholder's portion of the company.

The future years
Apple should continue to aggressively buy back shares while the stock price is undervalued. Doing so provides two major benefits. It boosts the earnings per share, because the total earnings of the company are being spread among a smaller number of shares. It also has the less-talked-about benefit of retiring shares that will have to pay dividends in the future.

For example, say that a company trades for $100 per share and pays out $0.50 per quarter in dividend payments. Every share retired increases every other shareholder's piece of the pie, and reduces the dividends needed to be paid out for the following year by $2.00.

As Apple continues to buy back shares aggressively, I suspect that, at some point in the future, management will decide that the market is fairly valuing the company. When this happens, there will be a capital allocation shift from mostly buybacks to mostly dividends.

Let's go back now to the previous example where the company saves $2.00 in dividend payments in the first year. What happens when the payout spikes to $0.55 per quarter next year, and $0.61 per quarter the year after that, and so on? The savings from retiring that share multiply -- $2.00, then $2.20, then $2.44, and on and on.

Now imagine this on the scale of Apple, and how it has already reduced its net outstanding shares by almost 700 million -- with more reductions on the way. This is great for EPS growth now, but even better when Apple becomes a mature dividend payer in the future. The more shares that are retired now, the more concentrated (and large) the dividend payments can be in the future. 

Many ways to win
I think Apple has plenty of capital appreciation left in it, but also has the potential to be a wonderful dividend stock for many years to come. Management and the Board have done a great job allocating capital so far, and I expect this to continue.

James Sullivan owns shares of Apple. The Motley Fool recommends Apple. The Motley Fool owns shares of Apple. Try any of our Foolish newsletter services free for 30 days. We Fools may not 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.