Stock Splits: What's the Deal?

by Michael on Feb 27, 2013 · 1 comment

Photo of Train Track Splitting

Stock splits were in the news this week. There’s apparently a rumor going around that Apple might announce a stock split at today’s shareholder meeting.

If it happens, it could be as much as a 10:1 split, and the rumor ignited a mild rally in Apple share prices. But why does this matter?

From a mathematical standpoint, stock splits are a non-event. Yes, the number of shares increases when a stock splits, but the value of each share simultaneously decreases. At the end of the day, nothing has really changed. Or has it?

How do stock splits work?

All publicly-traded companies has a certain number of shares outstanding. This number times the share price is equal to the market capitalization, which is essentially what investors believe the company is worth.

When a company decides to split their stock, they issue additional shares to current shareholders. For example, with a 2:1 split, every shareholder gets one additional share for each share that they own. But the value of each share is effectively halved.

Why split your stock?

So why do companies split their share prices? Splits typically occur after a major (and sustained) runup in share prices such that the company’s share price is out of line with others in their industry.

The thinking is that lower share prices will increase accessibility to smaller retail investors who might otherwise shun a stock because it’s too “expensive.”

In the extreme, this is true. Consider, for example, Class A shares Berkshire Hathaway (BRK.A). These currently go trade for nearly $150k/share. Clearly, mom and pop investors won’t be loading up on BRK.A anytime soon.

Instead of splitting their shares, Berkshire Hathaway has issued Class B shares (BRK.B) which trade for a lower price — currently a shade under $100. But the two classes perform more or less identically.

Why did Berkshire Hathaway choose to do it this way? It’s complicated. But the upshot is that the B shares make it possible for everyday investors to own a piece of the company. It also relieves certain other issues related to the gift tax, etc.

Stock splits and performance

So that explains (in part) why the market likes stock splits. But why else? Investor ignorance and/or irrationality probably contribute to it. Share price alone isn’t indicative of value, but not all investors get that.

Which would you prefer? One share of a company worth $100 or ten shares of that same company worth $10/each? It shouldn’t really matter. And yet it (seemingly) does as companies that split their shares tend to outperform those that don’t.

Of course, it’s difficult to distinguish cause from effect here. Are these companies enjoying strong stock performance because they split their shares or did they split their shares because they’re in the position to outperform relative to their peers?

It’s probably a little of both, though the former is more likely to produce a short-term “pop” whereas the latter is more likely to contribute to sustained, long-term outperformance. Either way, you need to be careful not to outsmart yourself.

1 Jose March 29, 2013 at 4:40 pm

There always seems to be some kind of bounce after a split, I like splits, I can’t think of a single stock I have been in that has done badly after split!

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