Friday, February 8, 2013

Financial Alchemy: David Einhorn’s “value” play for Apple

If you are an Apple stockholder, yesterday was an eventful day. First, you had David Einhorn becoming more “activist” with his Apple holdings, moving from being just bullish on the stock to pushing for change. Second, Einhorn also unveiled his plan for Apple: the company should give its stockholders preferred shares in the company, with a 4% dividend yield. In pushing for the change, he is quoted as saying that doing so will “unlock billions of dollars in value".

There will be NO value created.. none.. 
Before I look at the trade off on and the alternatives to the preferred stock issue, let me dispense with the one part of his claim that cannot hold. Issuing preferred stock will not add value to the company, not one cent. Before I get accused of being a “theorist” or “academic” (which I now know are code words for much worse insults), let me explain my rationale:
  1. The first law of thermodynamics, applied to value: You cannot create value out of nothing and giving preferred stock to your common stockholders is a “nothing” act, as far as the value of the company is concerned. It will not increase the cash flows from operations nor will it alter the risk in Apple’s business. 
  2. The cost of capital will not change: This action will not change the cost of capital. At first sight, it looks like it should since the cost of preferred stock, at 4% (assuming that it trades at par) is much lower than Apple’s current cost of equity (which I estimated at 12% or higher). However, that savings is a mirage, since common stockholders will now have to price in the risk of the additional commitment that has to be met (the preferred dividend) into the cost of equity. If this were not true, every company with a healthy cash flow (Coca Cola, Microsoft, Google) could become a money machine, granting preferred stock to its common stockholders. 
  3. The constant PE ratio is a myth: The most cringe worthy argument that I read yesterday was the one that went as follows: Apple currently trades at a PE of approximately 10.2, $450/share on earnings per share of $44. If you grant each common stockholder a $100 preferred stock, with a dividend of $4, your earnings per share will drop to about $40, and preserving the same multiple will generate a value per share of $400. Add that on to your preferred stock that is worth $100 and you have valuation magic: you have created $50 in value. This is the worst kind of nonsense, since it is nonsense with a believable twist to it, and that is why it has been investment conman’s favorite tool over history. The PE ratio is not a constant, and it will change as you change the nature of your equity risk or cash flows, as you are in this case. 
Bottom line: If Apple’s share were trading at fair value today (let’s say, at $450/share) and each Apple shareholder were granted a preferred share, with a preferred dividend of 4% and face value of $100, here is what the shareholders will end up holding tomorrow: a common stock with a value of $350 and a preferred share with a value of $100.

But the price MAY be affected
While I would contest Mr. Einhorn's claims of "value creation", let me take a more charitable view of what he is trying to do. Perhaps, he is trying to unlock the “price’, rather than the value, a distinction that may make more sense if you read my post on value versus price from yesterday. To make this "unlocking price" argument, you have to not only assume that the stock is under valued (which I would support) but that the under valuation is occurring for a very specific reason. It is not because investors are misjudging the value of Apple’s operations but because they are not giving Apple credit for either its huge cash balance ($130 billion +) or its capacity to generate huge cash flows ($30-$40 billion/year), for one of two causes:
  1. There could a trust discount attached to the cash balance, because investors are worried that Apple might be tempted to do something stupid with the cash, and with this much cash, there is only one action that can do you significant damage and that is overpaying on a really large acquisition. 
  2. Investors may fear that while the cash builds up in Apple, they may never see the cash, because managers are so attached to it that they will not let go or because it is trapped and therefore unavailable for user, due to tax reasons. 
If investors are discounting cash for one or both of these reasons, the preferred stock may serve to increase the price because it commits Apple to returning the cash (in the form of preferred dividends) in perpetuity. Presumably, “relieved” investors will now breathe a sigh of relief and remove the discount on cash, causing the stock price to go up. The upside is limited to the discount on the cash. Even if cash is being treated as worth nothing today (which would be a 100% discount), that would translate into $140/share.

Even if we accept this argument, though, it is not clear that granting preferred stock to common stockholders is the optimal way to create this commitment. In fact, there are three alternate routes that the company can go:
  1.  Increase common dividends: The simplest and least involved alternative is to increase the common dividends per share from the existing level of $10.60 per share to a higher value. In fact, if you are looking at granting a $100 preferred stock with a 4% dividend to each common stockholder, you could create an almost equivalent commitment by just raising dividends per share by $4/share. I know that the commitment is a little weaker, since common dividends are not guaranteed, but given how sticky common dividends are (healthy companies very seldom cut common dividends), but not by much. In fact, since investors tend to build in expectations of growth into common dividends that will not get built into a perpetual preferred share, the net commitment effect may actually be neutral. 
  2. Buy back stock or pay a special dividend: If investors distrust you with cash or are discounting it, the best response is to return in right now, rather than commit to return it to the future. The problem for Apple, though, is that a big chunk of the cash cannot be touched unless Apple decides to pay the “differential tax” (between the foreign tax rate and the US tax rate) on the trapped cash (estimated to be $80 billion+ of the cash balance). With Apple’s cash balance, though, you could still put together a substantial buyback ($40 billion) and commit to more buybacks in the future. 
  3. Issue bonds: Instead of giving common stockholders shares of preferred stock, you could give them Apple bonds instead. The advantage of doing so is that you could now potentially have a value impact, not because your operations have magically become more valuable but because the government in its wisdom allows you to subtract interest expenses for tax purposes. Thus, if you were able to give each common stockholder an Apple bond with a face value of $100 and an interest rate of 3% (unlike the preferred stock, you cannot arbitrarily set interest rates at any level you want, since the tax authorities will object), the potential value of the tax benefit per share , using a marginal tax rate of 40% and a cost of capital of 12%, can be computed as follows:
  • Interest tax savings each year = $3 (.40) = $1.20 
  • Present value of these savings in perpetuity = $1.20/.12 = $10/share 
  • The commitment to make interest payments is far stronger than the commitment to pay preferred dividends, since the consequence of failing to make interest payments is default. That is why there is a limit to how many bonds you can issue, before the trade off starts to work against you. 
Faced with these four choices: the Einhorn preferred stock grant, an increase in common dividends, a stock buyback/special dividend and bond issuance, there is one final consideration to keep in mind. The common stockholders in Apple have to think about the consequences of each of these for their personal taxes. With the common dividends and buybacks, we are on familiar ground and the effect on taxes is straightforward. Dividends will be taxed at the 20% dividend tax rate for most individual investors, as will the capital gains that arise from a buyback and are close to equivalent (though there is a tax timing option embedded that gives the latter a slight advantage). With the granting of preferred stock or bonds to existing stockholders, there is an added tax twist to consider. The preferred dividends will get taxed at 20% whereas interest income from bonds is taxed at the ordinary tax rate (higher than 20% for most investors), giving preferred dividends an advantage over bonds (but not over common dividends/buybacks). In addition, from my limited understanding of tax law, the grant of bonds will be treated as income at the time of the grant whereas the grant of preferred stock will not. (Thus, the Apple stockholder who receives a $100 Apple bond will be treated as having income of $100 in the year of the grant, whereas the receipt of $100 in preferred stock will just reallocate the basis for the Apple stockholding). 

Bottom line: If the objective behind the preferred stock is to remove the “trust” or the “trapped” discount on cash, why create a complicated mechanism, when a simple one will do? Just raise common dividends, if you do not want to open the door to debt at the moment, but leave that door ajar for the future.

Preferred Stock: The Big Picture
Contrary to many reports that I read yesterday, preferred stock is neither widely used nor is it favored by mature, non-financial service companies and for good reason. It brings many of the disadvantages of debt into a company (the fixed commitment, albeit with lesser consequences for failure to pay) without the tax benefit. In fact, there are three big users of preferred stock and Apple does not fit into any of the three categories:
  1. Control freaks: The use of preferred stock is widespread in some parts of the world, such as Latin America, but it takes both a different form (from US preferred) and often has a different motive. In much of Latin America, preferred stock does not entitle you to a fixed absolute dividend but instead gives you a first claim on the dividends and a percentage of the profits. Thus, these preferred shares are really common stock without voting rights. They are used by companies, where insiders hold the voting shares and have no desire to be accountable to the capital markets. 
  2. Young and start-up firms: Young firms often use preferred stock to raise capital because they want to raise capital, without diluting the existing owners’ stakes in the companies. For these companies, the tax benefits of debt are irrelevant in the decision process, since they are often money losers, and the risk of default is too high. To sweeten the pot for investors, they will often add the option to convert into equity to the preferred stock (creating convertible preferred shares). 
  3. Financial service firms: Financial service firms use preferred stock because some measures of regulatory capital allow them to count preferred stock as part of capital. Thus, while they view preferred stock as expensive debt (since it does not have the tax advantages), it does serve the purpose of augmenting regulatory capital. 
Studies of both US and European companies suggest that when CFOs are asked about their preferences on raising funds, there is a financing hierarchy. Topping the list as most favored is straight” debt and at the very bottom of the list is preferred and convertible preferred. For non-financial service firms, the issuance of preferred is more a sign of desperation than it is of health. No matter what you think about Apple’s prospect, I don’t think you would view them as being desperate for new capital right now.

If David Einhorn’s idea is a non-starter when it comes to value creation and not particularly effective even as a price catalyst, he is not alone in his sales pitch. In fact, what he is doing is widespread among companies, consultants and banks and I would propose three changes in the way restructuring plans/ proposals are presented to investors and public.
  1. Stop using price and value as interchangeable terms: Much of what passes for value creation in many companies is not what it is made out to be. I have seen the hue and cry around stock splits, issuing tracking stock and accounting restatements of assets on balance sheets and wondered why we make such a big deal about these actions. All of these tend to be purely cosmetic and have no effect on value. However, they could impact stock prices, if there is a gap between value and price. So, let’s require truth in advertising. 
  2. When you talk about value enhancement or creation, be specific: If an investor, company or consultant claims that an action will enhance value, the onus has to be on the claimant to explain where the value increase is coming from. Simply put, it has to come from increasing cash flows in existing assets, reducing the risk in these cash flows, improving the tax benefit/default risk trade off or from growing more efficiently (improving competitive advantages). That is a broad canvas and every true value enhancing action has to wend its way through one of these paths. 
  3. If you are talking about price enhancement, say so: If you believe that taking an action will increase your price (and has nothing to do with value), don’t claim otherwise. Here again, be specific about what market mistake or friction you are exploiting. If at the limit, your argument is that the price will go up because investors are naive or stupid (which is the basis for the constant PE argument), you might as well say so. 
In closing, I am glad, as an Apple stockholder, that David Einhorn is rocking the boat, even if I think his proposal is the not the most effective catalyst or game changer. It opens the door to a healthy discussion about how Apple should deal with its large and growing cash balance, and that is a good thing for all concerned.


MC said...

Thanks for posting this.

Kyle Braund said...

Excellent overview!
When stockholders say "it's OUR money", how accurate is this?


lgadf said...

quick question, aren't you making the same mistake you claim Einhorn makes when you assume that if AAPL issued a $100 preferred stock it would trade at $100 given a 4% preferred dividend? why would it not trade at say $200 giving it an effective yield of 2% or $50 giving it a yield of 8%.

Anonymous said...

Not that I think it is a particularly good idea, but Einhorn's point (according to the BI interview) is that the preferred issuance allows Apple to retain a larger portion of their stockpile of cash than increasing the dividend.

John said...

I can understand why altering capital structure won't add value to the firm. But doesn't it add value to the equity holders?? As far as I can see, from the equity holders' perspective, the presence of perpetual preferred shares is similar to using debt. Aren't you implying that removing debt from highly geared companies like DNB won't destroy values from shareholders?

Or let me ask it this way: What if we alter Einhorn's proposal. Instead of issuing preferred shares, we ask Apple to gear up its balance sheet by adding debt, and then pay out the proceeding as dividends. Does it generate value for shareholders?

What do I miss?

Anonymous said...

Einhorn's ambition to "unlock value" isn't synonymous with "value creation". It's synonymous with closing the gap between value and price. If he had said "create value" that would be another matter.

Anonymous said...

One advantage of Einhorn's proposal is that the shareholder receives an instrument, with no immediate tax consequences. Aapl keeps cash, incurs no debt, incurs annual obligation equivalent to 20% or 40% dividend increase (depending on whether $50B or $100B preferred issued). Preferred may be sold (assume at par), triggering capital gains tax (assume long term), and thus shareholder may extract 10% or 20% of investment in aapl, for whatever needs, at same tax cost as selling existing common shares, but without diminishing percent interest in aapl's future growth. That seems to be an advantage.

Anonymous said...

Could it not be that the investment community for preferred stock (such as ETF) is sufficiently robust (given the aging and differentially wealthy population looking safe return) that it will create a premium price for the Apple preferred, thereby enhancing the total wealth of AAPL investors at the time to the grant?

Also, for the general public of average investors, longterm capital gains are taxed at 15%, as are qualified dividends, which enhances the advantages of the preferred scheme over using bonds.

Anonymous said...

Didn't Einhorn say "unlock value", and not "create value" as you appear to be implying ... Did you read his points too quickly, as you were rushing to "pass judgement" in this public post ?

Unknown said...

Excellent post! May I ask which of those options you feel to be most beneficial?


Aswath Damodaran said...

I think that there is an easy way to assess what the price of the preferred will be, at least for the initial round. The risk free rate is about 2%, the pre-tax cost of debt attaching a rating of AA+ or AAA will be about 3-3.5% and the preferred dividend yield will be around 4%. it definitely will not be 2% or 8%.

Aswath Damodaran said...

The only reason that altering capital structure adds value is if what you are adding is debt. What causes it to change the cost of capital is not that the cost of debt is less than the cost of equity is that there is a tax benefit. There is none from issuing preferred stock.

Anonymous said...

Great blogs - I read them diligently. A question rather than a comment.

Is it silly to contemplate "Apple ABroad" which is holding the cash in foreign countries buying some ETFs that hold AAPL, redeem the ETF shares for underlying shares, and selling the non AAPL shares. Is this a reasonable way to reduce outstanding share count? I am sure there are issues here, but love to hear your thoughts on a better way
dilip naik

ADVILL said...

Great article...and reasoning, from my point of view (a small investor having 40% of portfolio in Apple)the most DEMOCRATIC way to share the wealth is with buybacks of stock.

I live in Europe and don´t know if the company can have a "self portfolio" that uses a way of benefit for the shareholders (reducing oscillations, buying low, selling high and buying low to share dividends.

But agree with you cash is a drug, and creates a chance of making something having it at 1% (below inflation).


John said...

I think I found my mistake. I forgot we were not reducing an equal amount of equity at the same time.

Anonymous said...

If Apple’s share were trading at fair value today (let’s say, at $450/share) and Apple shareholders were granted preferred shares, with a preferred dividend of 4% and face value of $500, what would happen to the price of the common stock?

Unknown said...

If Apple issued a $450 Billion preferred and it issued at par what would happen to the common? If it is not zero (and it wont be) where did the value come from? In theory there is no difference between theory and practice. In actuality there is!

Anonymous said...

Well said Vijay.

Aswath Damodaran said...

Vijay and anonymous,
Work it through. First, if you issue $500 of preferred stock to every common stock holder, the preferred stock will become much riskier (since you will need about $20 billion in earnings to cover those dividends). The preferred stock will then not sell at par but at well below it. Thus, if the risk led to investors demanding an 8% return on the preferred stock, the $500 preferred stock would trade at $250/share and the common stock has to trade at $200. So, stop thinking of it as a divide between theory and practice and just use common sense. Arguing that you cannot create value out of nothing is theory? Really?

Anonymous said...

Re:"I forgot we were not reducing an equal amount of equity at the same time."
Yes, but the stock price would not go down by the same percentage. Not even close.

jrt said...

Stern Stewart is cringing at the idea of constant PE! Edwards-Bell-Ohlson separated book value from earnings EVA which makes valuations less sensitive to terminal values...but I've struggled with high IP companies with mostly intangibles supporting book value. The market's fear of Lynch's Di-worsification is real but the bigger worry is changes in marginal R&D productivity which hurts ROE. Without large long-lived tangible asset bases (e.g. Intel) changes in R&D productivity can hide for a long time. Apple has lost its diversification with the iphone(it's a handset company now). On the positive side we may have seen the final consolidation in the phone biz a la PC's and Apple should be one of the top 3 winners if they make no management mistakes.

Jeff Teza

jrt said...

Buffett said it succinctly re: the 3 ways to add value.
1)Do more with the same
2)Do the same with less
3)Reduce your cost of capital

Changes to cap structure, or control does not change value unless it impacts the above. (PE uses debt to achieve 3) Buffett uses insurance company float).

Anonymous said...

I wonder why you think that Apple investors are being rational and are actually taking into account the paltry dividend when they buy into apple. What is the purpose of value investing? Isn't the purpose to find a mismatch between value and price? Einhorn's argument is that there is a vast difference between value and price. This difference can be unlocked by his mechanism. Your mechanism of buying stock/increasing dividends will not do that because presumably apple shareholders don't care about even 4% dividend. I think that his idea of fixed income investor types buying into the dividend paying portion is very interesting. In fact, he states that for every $50B in preferred stock, the common will go up by only $32 (before the distribution).

Max said...

If Apple is being penalized for holding cash, why isn't the solution to hold something other than cash? That is, buy a diversified basket of publicly traded (foreign) equity...along with a statement from management that they will not sell for the purpose of making acquisitions.

This gets rid of the cash without any tax consequences.

The only problem I see is that it reduces the idiosyncratic risk of Apple's stock, which may be a source of value (since people like to gamble).

Anonymous said...

No value can be created by any kind of maneuver. If the purpose is to deplete the pile of cash, how about issuing a Return of Capital to the shareholders. No tax consequences for shareholder, and AAPL is off the pressure of committing to future dividends. This may unlock investor's distrust while making little or no impact on future earnings. The stock price may thus move up (who knows!)


Anonymous said...

The price is obviously known whereas the value is unknown and there is no way of knowing it exactly because there are so many assumptions to make before getting at some kind of estimation of it. Now, we can believe given a set of reasonable assumptions that there is mismatch between the price and the value estimate, the latter being higher. In that case, you have first to convince people to your own value estimate before exploring technically the best way to bridge the gap, or... if really there is a gap between the price and the value why not just sitting around and waiting the price to converge to the value as the theory predicts...

Mamadou said...
This comment has been removed by the author.
Mamadou said...

The price is obviously known whereas the value is unknown and there is no way of knowing it exactly because there are so many assumptions to make before getting at some kind of estimation of it. Now, we can believe given a set of reasonable assumptions that there is mismatch between the price and the value estimate, the latter being higher. In that case, you have first to convince people to your own value estimate before exploring technically the best way to bridge the gap, or... if really there is a gap between the price and the value why not just sitting around and waiting the price to converge to the value as the theory predicts...

urban said...

Aswath, you are incorrect. Of course you can create something out of nothing. How does an insurance company create value if they do not decrease the rate of accidents? Simple, an insurance contract transfers risk from a risk-averse party to a risk-seeking party. The expected utility of both parties increases as a result of the transaction. When an AAPL shareholder sells his newly gained preferred share, something similar happens. An income investor, who seeks steady dividends but not the risk profile of a technology company that faces significant competitive challenges can pay a larger amount to the common holder (who is specifically seeking technology risk) than the value the common holder places on the income stream.

Aswath Damodaran said...

I am sorry but you need to rethink why insurance companies create value. It is not from playing off risk averse against risk seeking investors. It is from the pooling of risk that no individual can do by himself or herself and charging a price for that pooling. The power of the company comes from the actuarial tables.
As for the idea that there are these millions of investors lining up to buy Apple preferred stock at 4%. Are you telling me that they will pay a premium for these preferred stock? Why? What is so special about them? It is true that they represent safe income investments but they offer no price appreciation potential. So, why not offer higher dividends on the common stock. It is almost as assured and has the potential for price appreciation.
Here is the bigger problem. If your argument holds, the reason you want Apple to issue preferred stock has little to do with Apple and more to do with this untapped, vast market of "safe income" seeking investors that you foresee who will bid up this stock when it is issued. That "field of dreams" view of security issuance does not appeal to me.

Anonymous said...

Re" "Vijay and anonymous,
Work it through. First, if you issue $500 of preferred stock to every common stock holder, the preferred stock will become much riskier (since you will need about $20 billion in earnings to cover those dividends). The preferred stock will then not sell at par but at well below it. Thus, if the risk led to investors demanding an 8% return on the preferred stock, the $500 preferred stock would trade at $250/share and the common stock has to trade at $200. So, stop thinking of it as a divide between theory and practice and just use common sense. Arguing that you cannot create value out of nothing is theory? Really?"

Two words stand out as indicators of why your statement is likely false: "if" and "has". Given Apple's $137B in cash and >$40B in yearly cashflow the additional risk of paying $20B would NOT require investors to demand an 8% return in this rate environment. Secondly, you conveniently say that with the Preferred at $250 the common "has" to trade at $200. WHY? Because you deem it so? Youu are simply forcing the figures to fit your conception of what you see happening in theory. The market VALUE of Apple CAN and WOULD increase because investors would be willing to pay more for having access to a greater portion of Apple's cash.

urban said...

Aswath, your explanation for the value created by insurance companies is identical to my own just worded differently. The transaction does not alter the combined cashflows of the two parties. It simply transfers risk between them. Similarly, the combined cashflows to the preferred and common shareholders will be identical to those to the common if no preferred is issued. This fact is irrelevant.

Another example of risk transfer would be a CDO instrument. The underlying portfolio of the CDO does not change simply by its creation, but the CDO does create utility by assigning different risks to different tranches and matching those risks to different investors.

I was not arguing that an Apple preferred will trade above par. Priced "correctly", it will trade exactly at par. I was arguing that the common holders would NOT buy it AT par, and therefore if they can sell it at par they are gaining.

As long as different investors have differing utility curves, additional utility can be created purely through financial transactions. This is very basic economics.

Anonymous said...

I agree with Urban. The common and the preferred are different instruments with different target audiences that have different requirements for yield or safety. We are also in a very low rate environment, which increases the value of the preferred to a level that would not be attractive to an equity investor, but would be attractive to another kind of investor. There is nothing magical about it-- one group values something more highly than another and is willing to pay more. It is the same as a good negotiator finding things that the other side cares a lot about but which are not very important to the negotiator. By aligning preferences, "value" is seemingly created out of nothing even though you splitting the same pie.

Aswath Damodaran said...

I think that you are presenting an interesting scenario, where you propose that the following will happen. Apple will issue $100 billion worth of preferred (in fair value terms) and the value of equity will drop by less than $100 billion and they then sell the preferred at fair market value. Could it happen? I guess so, but I don't see a good reason why.
I did not deem it to stay at $450 billion. You did when you said that the common equity has a value of $450 billion at the start of the process. With no other claims on the assets, the value of the assets would also be $450 billion. While you see all this potential for creating magic on the liability side of the balance sheet, you need to tell me what is changing on the asset side to keep the balance sheet balanced. Are the cash flows from the assets increasing? If so, why? Is the risk in the overall cash flows changing? If so, where? Put differently, what is the issue of preferred stock doing to the asset side of the balance sheet? (At least, Urban's argument is one where the cost of capital will decrease, because equity investors are accepting a lower cost of equity than they should.)

Anonymous said...

Re: "I did not deem it to stay at $450 billion. You did when you said that the common equity has a value of $450 billion at the start of the process."

That is non-sensical.

I simply copied your example of a starting market cap for Apple immediately before the issuance of the preferred. You stated "If Apple’s share were trading at fair value today (let’s say, at $450/share) and each Apple shareholder were granted a preferred share, with a preferred dividend of 4% and face value of $100, here is what the shareholders will end up holding tomorrow: a common stock with a value of $350 and a preferred share with a value of $100."

And later in a comment you stated "...if the risk led to investors demanding an 8% return on the preferred stock, the $500 preferred stock would trade at $250/share and the common stock has to trade at $200." How did you come up with $200? Did you not assume the market cap stays at $450B?

Anonymous said...

Fantastic post Professor. Thanks for the illuminating responses to comments too.
Thanks a ton for enabling huge learning for many who may not have the luxury to take your classes.

Anonymous said...

Anonymous said...

Urban, your arguments appear to be in favor of creating a 'price' catalyst (not necessarily creating 'value') - these arguments may be similar to those of Einhorn...

Prof AD, (from what I understand) is attempting to distinguish price and value - I believe there is merit in all of us attempting to make such distinction (and not use these two terms interchangeably)

It may help to state our positions in a much better and clearer manner.

Angel Albamonte said...

Hi Aswath,

Great analysis.

Anonymous said...

Hi Professor,

Great analysis. Was hoping you could share your thoughts on linkedin too?


urban said...

Anonymous, I argued it is utility creation, not price catalyst. Couldn't have been any clearer. If you cannot address my actual argument, please refrain from adding noise to the discussion.

Aswath, there is another form of value creation which I did not address, which is increasing the utilization rate of an underutilized asset through capital allocation policy. Capital allocation is distinct from capital structure. I agree that changing the capital structure does not impact cash flows to the firm, but changing capital allocation certainly can.

Imagine that instead of $150B cash, that Apple owns $150B farmland. Imagine further that instead of farming and harvesting this land each year, that Apple simply leased it for $350M rent. Clearly, this would be an inefficient use of this asset. Apple could do many things to utilize the land more efficiently: it could (a) farm the land itself; (b) distribute land to the shareholders so that they could farm the land; or (c) buy another $500B of farmland using the original farmland as collateral, and then spinoff the new farmland to its shareholders. You could argue about what Apple should do, but almost anything would be better than letting the land lie fallow.

Einhorn's proposal is most similar to (c), but the analogy itself is not important, the important thing is that the asset be utilized. This is an investment decision by the firm as much as it is a capital structure decision, and investment decisions do affect cashflows. You could argue that Apple "could" do the equivalent of (a) or (b) instead of (c), and therefore (c) has no value above (a) or (b), but this is a silly argument because Apple has already ruled out (a) and (b), and (c) creates value above the status quo. Einhorn is being pragmatic and seeking a solution that management can live with.

urban said...

Let me use a very simple analogy for the theory of utility. Suppose that I like bananas and Aswath likes oranges. However, at the moment, I have an orange and Aswath has a banana. I offer to trade with Aswath. At the conclusion of our trade, we are both happier, but no additional fruit was created.

A share of Apple right now is like a basket with an orange and a banana. By splitting the basket and allowing the oranges and bananas to trade separately, investors who value oranges more and investors who value bananas more gain more utility from (and can rationally pay more for) all of the bananas and oranges than those investors could have paid for all of the baskets of oranges and bananas.

Swing trader said...

Would it be easy and inexpensive for Apple to list it shares in another exchange in Asia and/or Europe and then initiate stock buybacks without having to pay the differential tax on its cash hoard?

Anonymous said...


What happens when a company with a debt free balance sheet is trading so cheaply that the company could issue bonds to the market and pay out the proceeds as a special dividend? Theoretically the only value created would be to cost of capital changes and tax interest savings. But if the dividend (after taxes) per share paid to shareholders exceeds the current price of the stock then the shareholders receive all their equity back but still have an equity claim on the company that has some value greater than zero. In the Intelligent Investor Graham says that a company is worth at least what a prudent lender would lend to the company.


Kos said...

I'd prefer to see some serious M&A to reassure investors to demonstrate their desire to continue to innovate and not just become another value name. [FD: long the common but concerned]

Aswath Damodaran said...

Your argument is neither a bad one, nor is it new. It is based on the notion that markets are incomplete and that the Apple preferred stock will fill a void. In fact, the argument that you can divide cash flows into different pieces and sell each piece to an investor who would value it highest was at the basis of the the CMO and mortgage backed security market. You essentially were slicing up the cash flows into different parts: from safest to riskiest and selling it to the highest bidder.

That experience also offers a cautionary note. When anyone claims to have found a void in the market, they have to show that such a void exists. If it does, here is how it should be showing up now. The existing preferred shares from top notch issues (say those of the most solid of the banks and insurance companies) should be trading at premiums. If they are, I think that you can go ahead with the rest of your argument. It would not be specific to Apple, though. It would be that all cash flow generating, mature companies should issue preferred stock.

vedran said...

I think both of them are right and wrong. Einhorn math doesn't work - if he thinks that $500 preffered would trade at par than why wouldn't than AAPL issue $1000 preffered or $2000?
But i also think that Aswath's logic is little bit wrong. There is a long history of these cosmetic changes that worked and they increased price of the stock. For example spin offs. Sometimes managment spin off part of the company because it thinks that market isn't valuing it right because it's different business than core business. And it changes the price. But not over night so I think if issuing of preffered happens( i doubt it) both of them will say they were right when price increases.

Aswath Damodaran said...

I agree with you, and perhaps it is semantics (and I made a big deal of this in my last post). You can increase prices with cosmetic actions but you cannot increase value. If you use the two interchangeably, then of course all bets are off. Much of the disagreement in these comments can be traced to the distinction between the two.

Craig said...

Hi Aswath

Isn't a profitable company with a higher dividend payout ratio worth more (i.e. have a higher "value") than one that hoards cash at bank rates, if we assume the company has more cash than it has investment opportunities that generate returns above its cost of capital.

This is because a shareholder gets more value by getting the immediate use of the cash which they can then deploy elsewhere at or above their own cost of capital - i.e. they capture the time value for themselves rather than have it stagnate in the company coffers.

My understanding is that the payout ratio of a company is directly related to it's true 'value' depending on the investment opportunities it has.

In which case, would Einhorn not be correct in saying that the company could unlock significant "value" by releasing cash to shareholders - if you believe it has more cash than it can profitably use - even if the delivery method of the cash is arguable? (about which your points make perfect sense to me)

Thanks in advance for your thoughts


P.s. I am truly humbled by your generosity and passion for sharing knowledge - simply amazing.

Anonymous said...

I guess everyone's argument regarding creating value out of preferred is incorrect. Prof. Damodaran is right in his thinking. You cannot create value out of nothing. Ask yourselves these questions; by issuing preferreds are you 1) incresing cash flows 2) increasing growth in cash flows 3) making cash flows safer. I guess all answers would be in the negative. Naturally then Apple's intrinsic business value cannot change due to preferreds.
Coming to the price of stock, you and I don't know whether 450 per share (total 450 billion)is the correct stock price. But what we do know is markets will eventually catch up with the fundamentals. Whether you issue preferreds or bonds of equivalent safety would not matter. Temporarily you can cheat markets by doing these gimmicks. Over time markets will recognize the true worth though. The so-called unlocking in this case for Apple is total crap.
Apple has got bigger issues to deal with: 1)Identifying growth through innovation 2) Maintaining margins 3) Increasing market share 4) Returning cash to shareholders if it cannot identify investments. Only good way to return cash is by doing buybacks. It is a good opportunity for a disgruntled shareholder who wants to exit and for pro-Apple shareholder who wants to continue. Apple shareholders are not used to cash dividends. So it would matter less.
Creating value from thin air is a joke. Please stop talking about it unless you are actually cracking jokes.

- sp

Anonymous said...

Academics in ivory towers splitting semantic hairs. Do something useful and go find an excellent actionable investment idea. Until then, my money's on Einhorn and practitioners like him.

Vedran said...

I tought about this and i concluded that the basic idea behind this move is a difference how market treats debt (or preferred equity) and common equity. 4% or something like that on preferred for apple wouldn't be that strange in this low yield environment. on the other hand apple earnings yield is about 10%. So, this could work. Not just for Apple but also for other low debt companies. How long? Until that big spread exists.

Baskar Venkat said...

Dear Prof Damodaran,

Thanks a lot for your Knowledge sharing. The whole idea revoles around "How Apple can use this cash pile to reward/generate wealth/value for shareholders?"

A way for a company shall be providing dividends or capital gains which happens with consistent demand for the company's stock in the market. This demand can be sustainably created only by increasing cash flows, market share growth or by reducing firm's risk(or cost of capital) As the options such as preferred stock seem to create artificial value momentarily, markets would weigh them and soon a correction would occur to accomodate the changes.

From one of the options in your post, Buyback has been mentioned as a plausible route. The benefit which a company provides should be for existing shareholder progressively futuristic, but through buyback, anyone who gets the benefit is no longer a shareholder. At the same time promisisng future buybacks could also be risky as the market factors these promises and price rises over and above in market with some amount of increase traceable to this announcement alone and hence it becomes detrimental for the company to fix a buyback price over and above market price level prevailing in future date.

So how does buyback as an option create value?

Anonymous said...

aswath perhaps you should clarify by saying "value of the business", so you dont get self righteous commentators obnoxiously making a fuss over basically nothing. yes preferred stock creates utility value and thus affects the stock price, but it does not create additional value of the business. in saying "you cant create something out of nothing" aswath was clearly referring to value of the business!

Anonymous said...

I read: "If you believe that taking an action will increase your price (and has nothing to do with value), don’t claim otherwise".

So when you have a model that assumes
(1) Drivers of intrinsic value.
(2) Drivers of “the gap”.
(3) Drivers of price.
one should make sure, as you state, that the existence of such drivers is validated by (scientific) evidence. The solid scientific investigation of the existence of a specific driver implies that the market dynamics of the past should reveal the causality between the drivers you define and the specific effects they cause. Searching for causal relations in any collection of data can be performed by standard mathematical techniques. So if you make a model that certain actions drive intrinsic value, shouldn’t you first confirm the existence of the hypothesized causal dynamics with the vast amount of data that is available? I may be wrong, but in your writings and classes, I only can spot some fragmented evidence of the causality assumed in the model you use.

Universeofrisks said...

Theory aside, I wouldn't like to see Apple increase dividends instead reduce business risk by diversifying into other avenues. The idea of a tech company issuing increasing dividends doesn't sit well with me as it creates a culture of laziness with regards to innovation. I personally don't think Apple is a mature company yet, I don't think Apple should ever try and achieve maturity in the traditional sense of the word. I'd much rather see it evolve (over time) into a quasi mutual fund(Berkshire Hathaway) and not a Microsoft.

Zain said...


Most of your value appears to be coming from a trending down of your cost of capital to 8%. If you remove that assumption, you would arrive at a stock value pretty close to the current price.

Are you trending the cost of capital down because you are making an implicit assumption that the company will lever up?

I agree with you that Apple issuing pref. shares would be a daft strategy for Apple or its shareholders right now. If people care so much about the cash, then Apple should declare a one-time dividend on its common shares.

Anonymous said...

or, to unlock price Apple could just do a 10 for 1 stock split and watch the price soar to new heights. This would be the easiest and quickest method to unlock price. It would also cost Apple nothing.

Anonymous said...

or how about 100 for 1 stock split? It will become truly widely held and will rise in price quickly.

shoul said...

Wonder what you think of the preferred stock idea in the context of being eligible for the 15% tax rate for Institutional holders (I assume this why Einhorn suggesting preferreds versus other ideas) and how that would increase PV per share ?

Anonymous said...

My comment might be seen as irrelevant as your post is on Apple. However, I think investors should look to Samsung,now as its truly offering the company some competition. I would love to see you assigning a value to SAMSUNG given its potential of growth in the Emerging Markets and European Countries.

Unknown said...

Great post, Professor, as always. Wouldn't an added benefit of a common share dividend be that it would lower the beta of AAPL from its level of 1.05 by providing smoother returns in the form of dividends (which are uncorrelated with broader market moves)? In that sense, wouldn't a common dividend actually be creating "value" for the firm? And that is before we consider the many new investors who might join (pension funds?) for the extra dividend.

Anonymous said...

Hi professor,
Based on your analysis, if a preferred stock were issued, the price and/or value of call options will go down. Therefore, if you wanted to benefit from it, you must hold the underlying.
Am I right?
Thank you and regards

RedRut said...

fantastic overview Professor. I myself was trying to consider what additional value this would create and I guess the only reasonable answer is if the money is discounted in everyone's valuation.


Apple is down from 700 to around 450 today the stock most likely has much further to decline before it bottoms out.

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Anonymous said...

From a common stock shareholder's perspective, wouldn't this be cataclysmic? Is there a provision for current common stock holders to have a proportion of their shares converted to preferred shares? If not, why does Einhorn even want this, considering that the dollar value of his common share holdings will decrease overnight, even if he does nab a significant amount of the preferred stock?

Stefan Loesch said...

Aswath, excellent post, and I agree with all of your points, except that in my view you missed the most important one: issuing the preferred's allows Apples shareholders to reap the benefits of any future repatriation tax amnesty (which IMHO is certain to come at one point) already now which is particularly important if are a hedge fund and you have leverage constraints and an absolute return target.

The way it works is that by promising to pay $4bn pa Apple can hand their investors a paper that they can sell now for $100bn (using the suggested 4% yield). Once the tax amnesty arrives Apple onshores the funds and buys back the bonds. Done

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Look at the Shipping companies, realestate companies that split into REIT - Property Co & Operating Co. Dividing the risk and finding different buyers with different cost of capital created a divide 2 and get 3 or 4 in value.
The post is academically right but practically wrong. The market is not as efficient or logical as the professor professes.

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