<FOOLISH FOUR PORTFOLIO>
What Is a "Share"?
And what's your favorite pie?
By Ann Coleman (TMF AnnC@aol.com)
Reston, VA (February 1, 1999) -- Imagine yourself in an old fashioned diner. To your right is one of those silver pedestal pie stands with a domed glass cover. In it is a coconut cream pie. To your left is a similar pie stand with Dutch apple. You love them both. You can't decide which to have with your 16 oz. tumbler of cold whole milk. (It's OK. Daydreams can't clog your arteries.)
You can't decide... you can't decide... Arrrggggh! Your milk is getting warm. So you ask the waitress, "How much is a slice of pie?" Maybe one is a better deal. The coconut cream pie, she says, is $2 a slice. The Dutch apple Pie is $1 a slice. Well, heck, you say, I'll have Dutch apple.
Just as you get that first wonderful bite into your mouth, a tall, rangy stranger steps over the bar stool (you had to climb onto yours) and settles into place. He helps himself to a cup of coffee and waves the waitress over, pointing to the coconut cream pie. She serves him a slice.
Tarnation! It's twice the size of yours! You look more closely. Both pies are precut, the coconut cream into six slices, and the Dutch apple into 12. What do you do? Do you complain and ask for your money back? Do you fume and fret and resolve never to darken that particular diner's door again?
Not if you're a Fool. A Fool would just order another slice of Dutch apple, or be content with the one he has at half the price. It's the same thing.
For those of you who haven't "got it" yet (and those who have probably quit reading three paragraphs ago!), we are talking about the nature of a "share of stock" today. It occurred to me last week that one cannot grasp the idea of earnings per share without understanding just what a share of stock is -- and isn't.
A share of stock is like a piece of pie. What it is worth depends on what percentage of the whole it represents. If the slicer is my son, or Warren Buffet, a share of stock may be worth quite a large percentage of the whole. If shares were cut like my mother did her pie when some of her family unexpectedly dropped by around dinner time, you might find that a share of stock is worth only a small percentage of the company.
Say your pie is cut into 6 generous pieces when Aunt Sally and her three kids drop by. You cut each slice in two. You've "split" your slices. Like the pies in the diner, the split slices are worth exactly half the value of the original slice.
I guess we've milked this pie analogy for all it's worth. Just remember that no matter how you slice the pie, the pie doesn't get any bigger.
Possibly the most frequently asked questions we get here at the Motley Fool have to do with stock splits: Should I buy before or after the split? If I buy 100 shares before the split, and sell them after the split but before the new shares show up in my account, can I keep the additional shares? What happens to dividends when the stock splits?
All of these questions become moot when you realize that a share of stock is no more meaningful than a slice of pie. They can be split or even welded back together again, but what really counts is what percentage of the COMPANY you own. That is purely a matter of dollars and cents.
If you buy $1,000 worth of a one million dollar company, you own one one-thousandth of the company -- and if the shares split tomorrow, you will still own one one-thousandth of the company and be entitled to one one-thousandth of the dividends and one one-thousandth of the future growth of the company. If the shares split 2 for one, the dividend will be cut in half, but you would get a check for the same amount of money because you now have twice as many shares. It will always equal out.
If you buy stock before it splits 2 for 1, you will end up with twice as many shares after the split, but they will be worth half as much (minus the effects of market machinations). When you sell shares, what you are selling is the percentage of the company that is represented by those shares. So, no, you can't sell just before a split and keep the additional shares when they are finally sent to you (and shame on you for trying!).
Of course, the question about whether it is best to buy before or after a split is often asked in the context of investor psychology. What the writer really wants to know is how the stock will behave. There is a fairly widely held perception that stocks go up before and after a split. Statistically speaking, that is true, but it is far from a universal truth. What really happens is that stocks that are growing rapidly tend to split their shares, and that growth tends to continue for fundamental reasons, i.e. the company is making lots of money. But as someone who has personally watched three of my stocks split and drop like rocks, I can attest that there is a lot more going on than the split.
Often a split announcement will create publicity that, if the company has been growing nicely, can turn into hype, which tends to attract buyers and drive the price up, sometimes beyond any level that can be reasonably supported by future earnings. When the hoopla and hype die down, investors take a closer look. If the price is not justified by the company's earnings prospects, investors will desert it in droves. "Playing" splits is a dangerous game if you don't know the company well and don't have a good fundamental grasp of its value.
Our Foolish Four stocks split rather rarely, since we usually buy stocks that are not doing very well and sell them within a year, but occasionally one will rally so strongly that it splits while we are holding it. More often a company that has been doing well but is still underpriced (judging by its dividend yield) will split, and the lower price will propel it into the Foolish Four. These stocks usually do well, but not because they split. They do well because they are undervalued relative to the other Dow stocks. That's the same reason the other Foolish Four stocks tend to do well.
Tomorrow we will talk about the bookkeeping involved in stock splits.
Fool on and prosper!
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Stock Change Last -------------------- CAT + 3/8 43.69 JPM - 7/16 105.06 MMM - 5/8 77.00 IP + 7/16 40.00
Day Month Year History FOOL-4 +0.15% 0.15% -1.95% -0.49% DJIA -0.14% -0.14% 1.94% 1.53% S&P 500 -0.52% -0.52% 3.88% 4.13% NASDAQ +0.17% 0.17% 14.48% 16.05% Rec'd # Security In At Now Change 12/24/98 14 3M 73.57 77.00 4.66% 12/24/98 24 Caterpillar 43.08 43.69 1.41% 12/24/98 9 JP Morgan 105.51 105.06 -0.42% 12/24/98 22 Int'l Paper 43.55 40.00 -8.15% Rec'd # Security In At Value Change 12/24/98 14 3M 1030.00 1078.00 $48.00 12/24/98 24 Caterpillar 1034.00 1048.50 $14.50 12/24/98 9 JP Morgan 949.62 945.56 -$4.06 12/24/98 22 Int'l Paper 958.12 880.00 -$78.12 Cash $28.26 TOTAL $3980.32
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