This Billionaire Thinks That Apple Inc. Should Buy Back Stock At All-Time Highs

Activist investor Carl Icahn, who owns approximately 53 million shares of Apple , recently wrote an open letter to CEO Tim Cook asking for bigger share buybacks. Icahn also slapped a new "fair value" of $216 on the stock, up from his prior target of $203, indicating a potential 70% premium from current levels.

Source: Wikimedia Commons, WiNG.

In a previous article, I explained why $203 was already an unrealistic (albeit not impossible) price target.However, Icahn's new price targetis based on the assumption that Apple stock is still undervalued based on its forward P/E ratio. Let's see if Apple should heed Icahn's advice and repurchase its shares at all-time highs.

Apple's cash conundrumApple finished last quarter with $178 billion in cash and equivalents. However, it only has about $20 billion in domestic cash which can be used to repurchase stock, pay dividends, or make acquisitions. If Apple repatriates its overseas cash to do so, it will get hit by a big U.S. tax bill. That's why Apple issued billions in debt to help fund its buyback program.

Funding buybacks with debt won't slow Apple down, since the company still has a trailing 12 month free cash flow of nearly $60 billion. That healthy FCF will prevent Apple from falling into the "buyback trap" which snared IBM , where a company spends so much on buybacks that it neglects inorganic growth opportunities.

However, things get complicated when we focus on Apple's "effective" tax rate of 26.2%. On its income statement, Apple is required to include an income tax for overseas earnings, but Icahn notes that it is actually a "non-cash" tax since Apple won't repatriate overseas cash at today's U.S. tax rates. Therefore, Icahn states that Apple's "actual" tax rate is 20%, and that the remainder should be added back into its earnings.

Doing the speculative mathWith that adjustment, Icahn claims that Apple will earn $9.70 per share in fiscal 2015, significantly higher than Wall Street's non-adjusted consensus estimate of $8.59. Icahn notes that when the tax adjustment is applied, the consensus estimate rises to $9.31.

Icahn also expects Apple to grow its EPS at 20% annually from now until 2017. By comparison, Apple's diluted EPS climbed 13.6% in fiscal 2014. If Apple launches a smart TV in fiscal 2016 (an idea which I completely disagree with), Icahn believes annual EPS growth could accelerate to 31%. Lastly, Icahn believes that Apple stock should be valued at over 20 times forward earnings, although it currently has a forward P/E of 14.

By combining those bullish figures and adding in Apple's net cash of $22 per share, Icahn believes that Apple shares could be worth $216, making its stock undervalued at today's prices.

Should Apple buy back more stock?Buying back stock will inflate Apple's earnings per share, making it easier for EPS to grow 20% annually. In his letter, Icahn points out that on Aug. 13, 2013, when Apple traded at $66.77 per share, his firm requested that Apple use its excess liquidity to buy back shares. Of course, Apple listened, bought back shares, and the stock subsequently rallied on robust iPhone sales.

Since Icahn believes that Apple stock is still undervalued, he believes that Apple will be getting a similarly good deal, although the stock has soared more than 70% over the past 12 months.Buying back stock also makes strategic sense because there aren't many things that Apple needs to spend its excess capital on.

Buybacks certainly make sense, but I'd rather see Apple spend its cash on raising its dividend. Apple's current forward annual dividend yield is just 1.5%, considerably lower than Microsoft or Intel , which respectively offer yields of 2.8% and 2.9%.

Granted, the market still expects higher earnings growth from Apple, so it can still get away with paying a lower dividend. Yet Apple has much more room than either Microsoft or Intel to raise its dividend. The company has a trailing 12 month payout ratio of just 25%, compared to Microsoft's 46% and Intel's 42%.Apple's total dividends paid over the past year only accounted for 19% of its FCF, compared to a whopping 74% spent on stock buybacks.

The verdictIn my opinion, if Apple spent less of its FCF on buybacks and more on dividends, it could attract more income investors who favor higher yield tech stocks like Microsoft or Intel instead. For now, investors should take Icahn's buyback demands with a grain of salt and focus on the numbers that will matter most in 2015: iPhone sales and Apple Watch sales.

The article This Billionaire Thinks That Apple Inc. Should Buy Back Stock At All-Time Highs originally appeared on Fool.com.

Leo Sun owns shares of Apple. The Motley Fool recommends Apple and Intel. The Motley Fool owns shares of Apple and International Business Machines. 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.