Apple is hitting or is close to hitting two significant landmarks.

Its market cap exceeded $ 500 billion yesterday (2/29) and its cash balance is at $ 100 billion. The twin news stories seem to have set investors, analysts and journalists on a feeding frenzy. It is ironic that a company doing as well as Apple is right now, in terms of operations and stock price performance, is receiving this much unsolicited advice (split the stock, pay a dividend, buy back stock, do an acquisition, borrow money) on how it should fix itself. As we look at these prescriptions being offered to one of the healthiest companies in the market today, we should heed the Hippocratic oath, which is to do no harm. It is impossible to be objective in analyzing Apple and it is not just because the stock has done so well for me over the last decade. One reason that the debate on Apple is so heated is that people have strong preconceptions about the company and those preconceptions drive their suggestions about what the company should do. Choices for the company:

Is Apple's cash hurting its stockholders? The first and most critical question is whether Apple's cash holdings are doing harm to the stockholders. Let's dispense with the reasons that don't hold up to scrutiny: 1. Cash earns a low rate of return: It is true that Apple's cash balance earns a very low rate of return. It is, after all, invested in treasury bills, commercial paper and other investments that are liquid and close to risk less. It earns less than 1% but that is all it should earn, given the nature of the investments made. Put differently, cash is a neutral investment that neither helps nor hurts investors. 2. If that cash were paid out, investors in Apple could generate higher returns elsewhere: Perhaps, but only by investing in higher risk investments. Investors in Apple, who were concerned that Apple was investing so much in low return, low risk cash could have eliminated the problem, by buying the stock on margin. Borrowing roughly 20% of the stock price to buy Apple stock would have neutralized the cash balance effect and would have been a vastly more profitable strategy over the last decade than taking the cash out of Apple and searching for alternative investments. So, what could be defensible reasons for worrying about cash? Here are a few: 1. The "low leverage" discount: The tax laws are tilted towards debt and Apple by accumulating $ 100 billion in cash, with no debt, is not utilizing debt's tax benefits. In fact, the gargantuan cash balance gets in the way of even talking about the use of debt at the company; after all, why would you even consider borrowing at 2 or 3% interest rates, when you have that cash balance on hand? Apple's optimal debt ratio is about 40-50% and its current net debt ratio is -20%. Given the risk of the business that Apple operates in, the debt ratio should not go higher than 20-30%. Their cost of capital currently is about 9.5% and it could drop to about 9% with the use of debt. That would translate into a value increase of $20-25 billion for the company, not insignificant but that is about a 5% value increase.

2. The naivet discount: It is undeniable that legions of investors still use the short hand of a PE ratio, often estimated by looking at an industry average, applied to current or forward earnings to get a measure of whether a stock is cheap or expensive. In the process, they can significantly under value companies that have disproportionate amounts of cash. To see why, assume that the average trailing PE ratio for electronics/computer companies is 14 and that the average company in the sector has no cash. If you apply that PE ratio to Apple's net income or earnings per share, you are in effect applying it not only to the earnings from its operating assets (where it is merited) but also to its earnings from its cash balance (where you should be using a much higher PE ratio). Thus, you will come up with too low a value for Apple. 3. The stupidity discount: In a post on Apple more than a year ago, Damodaran referred to what is called the stupidity discount, where stockholders discount cash in the hands of some companies because they worry about what the company might do with the cash. If investors are worried that the managers of a company will find a way to waste the cash (by taking bad investments, i.e., investments that earn less than the risk adjusted rate of return they should make), they will discount the cash. Assessment: As an Apple stockholder , the company had earned the trust and that it was okay with them holding cash. One should be open to a reassessment and any disagreement boil down to the answer to the following question: Do you believe that Apple's success and strategy over the last decade was attributable to Steve Jobs or Apple's management? If you believe it was Steve Jobs, you are now in uncharted territory, with Tim Cook, a capable man no doubt, but capable men (and women) have wasted cash at other high profile companies. If you believe that Apple's management team was responsible for its success over the period, your argument is that nothing has really changed and that you see no need to change your views on the cash.

What if there is no discount? If the cash balance is not hurting Apple's stockholders right now, the pressure to return the cash immediately is relieved. However, you still have a follow up question to answer. Does Apple see a possibility that it could find productive uses for the cash? While Jobs never broached that question and preserved plausible deniability, Tim Cook has conceded on this issue, when he said last week that Apple had more "cash than we need to run the company". Bottom line: Apple is not being punished right now for holding on to $100 billion in cash. While one had the conviction that Steve Jobs could never be pressured (by investors, portfolio managers or investment banks) to do something he did not want to do, not as sure about Tim Cook. Having seen how quickly markets can turn on high flying companies (Microsoft and Intel in the early part of the last decade come to mind), in the face of disappointment or a misstep, Apple may be one misstep away from a discount being attached to cash. Given that even Tim Cook does not think that Apple needs this big a cash balance, it is time that we ask the follow up question: what should Apple do with all this cash? What should Apple do with the cash? In the broadest sense, Apple can either invest the cash or return it to stockholders and it seems that even Apple does not believe in the first option. Investing the cash internally in more products and projects sounds like a great idea, given Apple's track record over the last decade. In 2011, for instance, the company generated a return on equity of 42% on its investments; if you net the cash out of book equity, the return on equity exceeds 100%. If Apple could invest the $100 billion in cash at 42%, that cash would be worth $350 billion, but put those dreams on hold, because it is not going to happen. First, that high return on equity can be traced back to the blockbuster products that Apple introduced in the last decade, the iPod, the iPhone and the iPad, and those are not easily replicable. Second, there are other constraints (people, technology, marketing, distribution, production) that essentially limit the number of internal projects that Apple can take. How about a few acquisitions? there are willing and eager bankers who will find target companies for Apple. The sorry history of value destruction that has historically accompanied acquisitions of large publicly traded companies leads me to believe that this path of action will provide justification for those who attached a stupidity discount in the first place. So, to those who are counseling Apple to buy Yahoo!, Pandora, Linkedin or go bigger, please go away! If Apple cannot find internal projects of this magnitude and the odds are against value creation from acquisitions, the

company has to return the cash to investors and there are three ways it can do this: initiate a regular dividend and tweak it over time, pay a large special dividend or buy back stock. In my view, there are four factors that come into play in making this choice: 1. Urgency: A company with a large cash balance that has been targeted by an acquirer or activist investors has to return cash quickly, cutting out the regular dividend option. Apple's large market cap protects it from hostile takeovers and its stock price performance and profitability give it immunity from activist investors. 2. Stockholder composition: When a company that has never paid a regular dividend initiates dividend payments, it attracts new investors, i.e., investors who need or like dividends, into the company. While this "investor expansion" has been used as an argument for regular dividends, I think it should actually be an argument against regular dividends. While some of my best friends are "dividend investors", I think that they are temperamentally and financially a bad fit for Apple, a immensely profitable company that also operates in a shifting, risky landscape. If Apple initiates a dividend, the demands for increases in those dividends in future years will come and the company will find itself locked into a dividend policy that it may or may not be able to afford. 3. Tax effects (for investors): The choice between dividends and stock buybacks is also affected by how investors in the company will be taxed as a result of the transaction. While both dividends and capital gains are still taxed at the same rate, that will change on January 1, 2013, when the tax rate on dividends reverts back to the ordinary tax rate (which could be 40% or higher). If Apple drags its feet into 2013, the choice becomes a simple one: buy back stock. 4. Valuation of stock: Finally, there is the question of whether the stock in the company is under or over valued. A company, whose stock is over valued, should pay a special dividend since buying back shares at the inflated price hurts the stockholders who remain after the buyback. Capacity of management to make judgments about the "fair" value of the stock is not the best, valuing Apple using an intrinsic valuation model, assumptions (8% revenue growth for 5 years and a 30% target margin, both significantly lower than the numbers from recent years), estimated value of $716 $710 per share for Apple. A buyback at the current price would provide a double whammy: a reduction in a "too large" cash balance and a buyback at a price lower than value. Closing thoughts Apple should announce a substantial buy back, but it should use it do so on its terms. First, the buyback should leave Apple with enough of a cash balance ( guess is about $15-$20 billion) to invest in new businesses of products, should they open up. For the moment, avoid the debt route, even though Apple has debt capacity. Second, Apple should follow the Berkshire Hathaway rule book and set a cap on the buyback price. While Berkshire Hathaway's cap is set in terms of book value (less than 110% of book value), Apple should set its maximum as a function of earnings or cash flows (say, 16 times earnings). Third, Tim Cook should stop talking about whether Apple has too much cash and get back to business. Make the iPad 3 a success and lets see an iTV, an iAirline, a iUniversity and an iAutomobile (think of any product you use now that is badly designed or a business that is badly run and think of how much better Apple could do...). Apple did not get to be the largest market cap company in the world by finessing its capital structure or optimizing dividend policy. It did so by taking great investments.