NYU finance professor Aswath Damodaran has posted an epic dismantling of David Einhorn’s recent plan to create value for Apple’s shareholders.
Quick recap: Yesterday, Einhorn, a major hedge fund manager, laid out a way for Apple to enrich its shareholders by offering preferred shares, a bond-like security that pays dividends into perpetuity.
Here’s the nut of Einhorn’s proposal:
…With this conservative action, Greenlight believes the Board could unlock hundreds of billions of dollars of latent shareholder value.
Assuming Apple retains its price to earnings multiple of 10x and the preferred stock yields 4%, our calculations show that every $50 billion of perpetual preferred stock that Apple distributes would unlock about $30 billion, or $32 per share in value. Greenlight believes that Apple has the capacity to ultimately distribute several hundred billion dollars of preferred, which would unlock hundreds of dollars of value per share.
Damodaran sees a lot of problems with Einhorn’s proposal.
In the first part of his argument, he makes it very clear in big bold letters: “There will be NO value created.. none.. ”
This was a position taken yesterday by Business Insider’s Henry Blodget.
“Issuing preferred stock will not add value to the company, not one cent,” writes Damodaran. The cost of capital won’t change, and the price-earnings ratio won’t be constant. He explains fully in his post.
In the second part of his argument, Damodaran gives Einhorn a bit of a break and suggests that “he is trying to unlock the ‘price’, rather than the value.” This suggests that investors are holding down the stock price for some other reason outside of intrinsic value.
Damodaran offers two reasons why investors might be holding down the price. Here they are verbatim (emphasis ours):
- 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.
- 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,” he writes.
But preferred stock isn’t the only way to send cash back to shareholders. Damodaran reminds us that dividends (common and special), buybacks, and bonds are all alternative ways for a company to release cash to investors. Each has various income tax matters to consider. He discusses each option in depth in his post.
From Damodaran: “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.”
And Damodaran’s issue with preferred stock doesn’t stop with complexity.
“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,” he wrote.
He notes that there are three types of companies that employ preferred stock (in his words): control freaks, young and start-up firms, and financial service firms.
Surveys show, according to Damodaran, that when a non-financial service firm issues preferred stock, it 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,” he says.
Anyone interested in this story should read Damodaran’s entire post at Musings on Markets.
But we’ll include his generous closing:
In closing, I am glad, as an Apple stockholder, that David Einhorn is rocking the boat, even if I think his proposal is … 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.