2/7/12

Stock Splits: much ado about nothing

There are lots of people talking about stock splits nowadays. “Will Apple [AAPL] split, do you think? I hope so, cause that'll make me rich!” “It would be so awesome if KMP [Kinder Morgan Energy Partners] did a stock split so we could get more shares and a bigger dividend!”

These kinds of statements, rife on the various finance message boards, make me shudder and put in stop loss orders. And not just because KMP has units instead of shares.

It's because stock splits are mostly meaningless. And when people who don't know this invest in the same things I do, I get nervous.

A stock split occurs when a company divides each of its existing shares into more shares. For example, suppose that corporation XYZ declares a 2-for-1 split. This means that if you own 100 shares before the split, you own 200 after.

Many people are unfortunately under the misapprehension that if this were to happen with the shares of a company that they own, they would double their money. And that if the company pays a dividend, if the rate stays the same, the dividend would also double.

Wouldn't it be awesome if it were true (putting aside the worry about where the company would find all that extra cash)?

Here's what happens with a stock split. Suppose corporation XYZ declares a 2-for-1 split. Let's say it has 20 million shares outstanding before the split and trades at $40 per share. That makes its market capitalization (the total market value of all its shares) $800 million.

After the 2-for-1 split, XYZ will have 40 million shares outstanding. Its share price, on the other hand, will be $20. Its market capitalization will stay the same, at $800 million. It'll have twice as many shares and these shares will cost half as much as before the 2-for-1 split.

Had XYZ done a 3-for-1 stock split, it would have three times as many shares (60 million) and its shares would cost three times less ($13.33333) than before the split. The company's market capitalization would stay the same at $800 million.

If XYZ paid a dividend of $3 per share before the split, it would pay $1.50 per share after a 2-for-1 split or $1 per share after a 3-for-1 split if its dividend rate ($60 million) remained the same.

So what the hell is the point of a stock split? If nothing changes, why do companies do it? There are a few reasons, but they're nothing to get excited about.

Stock splits can make the shares more liquid, as there might be more buyers for 100 shares at $20 than 50 shares at $40. Also, the split might signal to investors that the company is optimistic about the future (but wouldn't a good earnings report do a better job of accomplishing that? And wouldn't it be clearer if the company simply said, “we expect growth to the tune of x% for y number of years?). Finally, there's a psychological effect. A lower share price looks cheaper and might tempt more people to buy it, thereby increasing demand and sending it up. To the extent these are true, they only influence small investors, who have a negligible effect on the share price. That's about it. Studies haven't shown, as yet, that stock splits increase shareholder value.

In some sense share splits make it easier for smaller investors to buy a stock. This was especially true when investors could not buy odd lots (anything less than 100 shares). So, for example, if an investor had $1,000 and a stock he wanted to buy cost $1,000 per share, he wouldn't be able to buy it because he couldn't afford 100 shares ($100,000). If that stock did a 100-for-1 split, on the other hand, the investor would be able to use his $1,000 to buy 100 shares for $10 each.

Today, however, investors can buy odd lots. Through certain brokers they can even buy fractional shares. If you want to put $1,000 into Berkshire Hathaway's class A shares, currently trading somewhere north of $100,000 each, you can get a hundredth of a share through certain brokers. Remember, it doesn't matter how many shares you own. What matters is the monetary value of these shares and, in terms of voting for company directors and the like, what portion of the shares outstanding are under your control. Whether you own one share or a million, if it constitutes the same monetary value or stake in the company, the number doesn't matter. $1,000 in Apple is $1,000 in Apple, whether the stock costs $500 and you own two shares or the stock costs $20 and you own 50 shares.

So there's really no reason to split shares today. Moreover, it can be to a company's and its investors' detriment. The investment banks involved in the share splitting process don't do it for free, after all. Also, if your broker charges a per share fee for buying or selling, a stock split will increase your transaction costs.

So why do people tend think that share splits are a good thing? Stock newsletter ads and financial blogs are at least partly to blame for the misapprehension. When newsletter copywriters give their spiel about why you should spend your hard earned money on stock advice from people smart enough not to invest in the recommended stocks themselves, they often tell you a long story about how “Jim from Omaha bought 100 shares ABCD in 1890 and now, thanks to stock splits he has 2,395 shares!” and how “Mary from Springfield bought just one share of WXYZ in 1923 and now, thanks to stock splits has 400 shares!,” and so on. This makes it seem like it was stock splits that turned Jim and Mary into millionaires or whatever the ad says they or their relatives are now. But it wasn't. It was the companies' market caps increasing that generated the capital gains.
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While traditional stock splits may be neither good nor bad, reverse splits usually do not bode good things. A reverse split, as its name suggests, is a stock split in reverse. For example, a 1-for-2 split reduces the number of a company's shares outstanding in half and increases its share price by a factor of two. So if ZXY trades at $5 per share, has 100 million shares outstanding, and does a 1-for-2 split, it will trade for $10 per share and have 50 million shares outstanding.

Reverse splits are often done to comply with exchange regulations which require share prices to be above a certain threshold. Moreover, companies seem to think that people are less likely to buy their shares if they are under $10 (or $5 or whatever).

It's hard to think of any examples of a company's market capitalization going up after a reverse split. There are plenty, however, of the stock going down: Sun Microsystems (now part of Oracle), AIG, and Citi come to mind. If a company's stock price falls low enough to warrant a reverse split, that means its prospects aren't very good. A reverse split does nothing to fix this. It's like putting a smiley face bandage on a gunshot wound. It's quite amusing to watch, as long as you don't own the shares, the share price after the reverse split descend down to the price at which it started.

Stock splits, regular and reverse, do not change a company's prospects. They are cosmetic only.