Buffett is Right: Apple Should Buyback Stock

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During his appearance in CNBC´s Squawk Box on Monday morning Warren Buffet talked about his relationship with Steve Jobs, and remembered a telephone conversation he had with Jobs about the possible uses for Apple´s (NASDAQ: AAPL) cash reserves.

He said, ‘We’ve got all this cash.  What should we do with it?’  So we went over the alternatives.  It was kind of interesting.”

Buffett explained to Jobs that there are only four things you can do with cash: stocks buybacks, dividends, acquisitions, or “sitting with it.”

“I went through the logic of each thing.  He told me they would not have the chance to make big acquisitions that would require lots of money... And then I asked him the question, I said.. ‘I would use it for buybacks if I thought my stock was undervalued.’  And I said, ‘How do you feel about that?’  The stock was 200 and-something.  

He said, ‘I think my stock is very undervalued.’  I said, ‘Well, what better to do with your money?’  And then we talked awhile.  And, he didn’t do anything, and of course, he didn’t want to do anything.  He just liked having the cash.  It was very interesting to me because I later learned that he said I agreed with him to do nothing with the cash.  (Laughs.)  He didn’t want to repurchase stock although he absolutely felt his stock was significantly underpriced at two-hundred and whatever it was then.”

Buffett has recently been very vocal on the convenience of buybacks when a company has more cash than it needs to run its operations and the business is undervalued at current prices.  He elaborated in Berkshire Hathaway´s letter to shareholders on why he decided to buyback Berkshire stock in 2011 and how he felt very enthusiastic on the idea that IBM, a notable recent investment of Buffett was also buying back its own shares.

Basically, when a company is undervalued and has extra cash to use in financial operations, investors get an extra reward. When you invest in a company that is correctly buying back its undervalued securities, the company becomes an even better investment because management is giving a productive use to company´s assets.

Think of it that way: How is Apple going to make more money, investing in low risk securities that provide almost no return or buying its own stock at convenient prices? I´m quite convinced that the second one is a better alternative in the long term.

I believe Apple is still quite cheap even at historical highs of more than $540. In the following table we compare valuation ratios for Apple, Amazon (NASDAQ: AMZN), Google (NASDAQ: GOOG), Microsoft (NASDAQ: MSFT) and Oracle (NYSE: ORCL).

Apple is cheaper than Google and Amazon in terms of P/E ratio, and it is relatively in line with Microsoft and Oracle. However, the Cupertino company has much higher expected growth rates than Microsoft and Oracle. If we consider the PEG ratio, which divides P/E by expected growth rate, Apple is clearly the cheapest company in the group, with a PEG around 0.8 while the rest of the companies have PEG ratios above 1. It´s worth noting that Amazon is much more expensive than the rest of the companies with a PEG ratio of 4.9. 

<table> <tbody> <tr> <td> <p>Ticker</p> </td> <td> <p>Market Cap</p> </td> <td> <p>P/E</p> </td> <td> <p>PEG</p> </td> </tr> <tr> <td> <p>AAPL</p> </td> <td> <p>505.75B</p> </td> <td> <p>15.45</p> </td> <td> <p>0.82</p> </td> </tr> <tr> <td> <p>AMZN</p> </td> <td> <p>81.77B</p> </td> <td> <p>131.16</p> </td> <td> <p>4.87</p> </td> </tr> <tr> <td> <p>GOOG</p> </td> <td> <p>201.02B</p> </td> <td> <p>20.78</p> </td> <td> <p>1.11</p> </td> </tr> <tr> <td> <p>MSFT</p> </td> <td> <p>266.32B</p> </td> <td> <p>11.50</p> </td> <td> <p>1.25</p> </td> </tr> <tr> <td> <p>ORCL</p> </td> <td> <p>147.06B</p> </td> <td> <p>16.08</p> </td> <td> <p>1.33</p> </td> </tr> </tbody> </table>

Steve Jobs should have listened to Buffett and Apple would have made juicy returns by buying stock back at the “200 and something” level. Even more important, the stock is still undervalued, so Buffett´s advice is still valid.

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