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Understanding Stock Splits

Invest - Smart DecisionEvery now and again, companies will execute what is call a stock split or even a reverse stock split. It seems to create chatter amongst investors when a stock split is announced by the board of directors but the reality is that a stock split doesn’t change anything to the underlying company value. The company is worth exactly the same.

For example, take Company X which operates in the drink business and have a stock price of $100 and they have 1 million outstanding shares for a total value of $100 million. In any of the scenarios below, the value will stay the same:

  • 2-for-1 : 2 million shares * $50.00 per share = $100 M
  • 3-for-1 : 3 million shares * $33.33 per share = $100 M
  • 4-for-1 : 4 million shares * $25.00 per share = $100 M

The board of directors will usually be in favor or not depending on whether or not they feel their stock is being valued as the expect for the investors. Some companies have not gone through any stock split such as Berkshire Hathaway (BRK.A – Warren Buffett’s company) and others such as Google and Apple have opted to let their stock price stay high. Apple has done stock splits in the past around the $200 mark but not since the stock became a fashion :)

Another stock I have seen recently is Potash (POT) which has done a stock split in 2004, 2007 and 2011. It usually means that the stock is desired at a certain level and that the stock is performing rather well.

It’s important to note that dividends will also be adjusted for stock splits and it might be in your favor. Let’s say you have enough shares to generate $50 in dividends, which of the scenario above would allow you to DRIP? All 3 of them initially. The 2-for-1 would probably not last long unless the price goes down. Stock splits can in fact accelerate your compounding machine.

Stock Split

It’s all about the psychology of the investors. When a stock is mostly owned by institutions, it may not matter much but when there is interest by regular investors, there is a big difference if your $5,000 buys 10 shares or 100 shares. The investor psychology comes into play here and if a stock split gets momentum, the market cap can change and it can affect mutual funds and ETFs that now have to adjust.

Reverse Stock Split

A reverse stock split does the opposite by reducing the number of shares outstanding. A reverse stock split can have a psychological effect but more importantly it can help a company that struggled be seen by large funds. Some regulations prevent some of the funds to buy companies with stocks in the lower single digit so when a reverse stock split happens, it can bring the stock back in line for those funds to buy. Note that the market capitalization is unchanged and ignore by the funds until the price reaches a level acceptable. At which point, the purchases are initiated. Citigroup pulled such a move in 2011 when it executed a 10-for-1 stock split to get their stock in the $40 range.

A reverse stock split can also prevent a stock from being delisted in case it is trading too low.

Aside from manipulating institutional investors, stock splits are purely mind tricks but it does create chatter and anticipation. Often times, the stock will tend to run up and the question is whether or not it stays up after the split once the excitement is gone …

Readers: What’s your take on Stock Splits?

Image courtesy of Master isolated images – FreeDigitalPhotos.net

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