FOOLISH FOUR PORTFOLIO

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More About Splits
They're definitely a headache!

by Ann Coleman (TMF AnnC@aol.com)

Reston, VA (February 3, 1999) -- Let's tie up a few loose ends on yesterday's question of stock splits.

First, observe, if you will: The Motley Fool's Charts: CAT. That link takes you to a chart of Foolish Four resident Caterpillar (NYSE: CAT). It goes back 10 years, and it appears to indicate that in early 1989 CAT was selling for around $15 a share.

BUT, if you were to pick up a local paper printed on February 3, 1989, you would see that CAT was actually selling for around $58.00. Something's missing. It's this: The Motley Fool's Charts: CAT2. The second chart notes when splits occurred.

All charts are split-adjusted, as are most historical stock price quotes, meaning that when a split occurs, the price is split all the way back. This allows the chart to accurately give a visual representation of the company's share price growth. If these charts simply plotted actual prices each day, CAT would appear to have undergone several severe corrections where the price was halved in one day. Alarming.

If you are confused about splits, remember the First Rule of Stock Splits: Everything adjusts -- nothing can ever be gained or lost just because of a stock split. Accountants have been doing this for a long time, and they've pretty much got the kinks out. You just won't find examples where this is not true, although it sometimes takes a while to get everything adjusted.

Here is how a two for one (2:1) stock split happens on the company's books. First, the number of shares outstanding is doubled, because each shareholder will be receiving an equal number of shares. After that, anything that uses Shares Outstanding in its calculations is recalculated using the new number. For example, EPS is Earnings per Share. The company's total earnings are now divided by twice as many shares, so the EPS number drops by half. Same for dividends. The Dividend Pot is now spread among twice as many shares, so the actual dividend is cut in half.

Does this matter? Not a bit. If you are a current shareholder, your dividend check will be exactly the same, because the new dividend amount is now multiplied by twice as many shares.

If you are considering buying the stock, investing the same amount of money will get you the same dividend check, because that same amount of money will buy you twice as many shares. The yield is unaffected. Yield = dividend/price. When the stock splits, both dividend and price are halved. If the pre-split yield is 2%, the post-split yield is 2%.

Ex. Before split:
Dividend = $1.00
Price = $50.00
Yield = 1/50
= 0.02 (2%)

After split:
Dividend = $0.50
Price = $25.00
Yield = .5/25
= 0.02. (2%)

If you are a prospective investor, do you quail because the EPS has been cut in half? I hope not. If you check the growth of EPS, you would see that all the past EPS numbers have also been cut in half (eventually they will be, anyway). The growth of earnings is exactly the same. Total earnings and, most importantly, prospective earnings are unaffected.

Say you own a company that is merging with another company in a stock-for-stock swap. Both are selling for $50, so the swap is even -- one share for one share -- but the other company splits. You can safely assume (remember Rule 1) that the terms of the merger just changed. The stock swap is now one share of your company for two shares of the other company.

I've been talking about a simple two-for-one split, but all other kinds of splits work the same way -- the math is just a bit more difficult to envision. For example, a 3 for 2 (3:2) split means that every two shares you own are replaced with three. To see how that affects the price per share, you think, I have two shares worth $15 each, so each bundle of two shares is worth $30. That will be replaced with a bundle of three shares that will also be worth $30, so each share will be worth $10.

I hope this makes it a bit more clear why stock splits simply cannot affect long-term company stock performance other than the small effects of hype (which tend to dissipate with time) and of keeping the stock in a price range that is appealing to people and makes buying into the company more convenient. If this is still not clear, you might want to review yesterday's column on splits and last week's columns on why stock prices really rise.

It's fun to have twice as many shares, but the alternative would be to have the same number of shares that are worth twice as much.

Friday: A look at how our portfolio is doing -- or not doing -- so far, anyway. Is there a problem? Or is it too soon to worry?

Fool on and prosper!

The Fool is hiring. Answer the call.

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Today's Stock Lists | 1998 Dow Returns

02/03/99 Close
Stock  Change   Last
--------------------
CAT  -   3/16  43.13
JPM  +1  7/16  104.25
MMM  -1  1/4   74.63
IP   +   3/8   41.56
                   Day   Month    Year   History
        FOOL-4   -0.02%  -0.35%  -2.43%  -0.98%
        DJIA     +1.00%   0.09%   2.17%   1.76%
        S&P 500  +0.80%  -0.59%   3.80%   4.05%
        NASDAQ   +1.22%  -0.50%  13.71%  15.27%

    Rec'd   #  Security     In At       Now    Change

 12/24/98   14 3M            73.57     74.63     1.43%
 12/24/98   24 Caterpillar   43.08     43.13     0.10%
 12/24/98    9 JP Morgan    105.51    104.25    -1.19%
 12/24/98   22 Int'l Paper   43.55     41.56    -4.56%


    Rec'd   #  Security     In At     Value    Change

 12/24/98   14 3M          1030.00   1044.75    $14.75
 12/24/98   24 Caterpillar 1034.00   1035.00     $1.00
 12/24/98    9 JP Morgan    949.62    938.25   -$11.37
 12/24/98   22 Int'l Paper  958.12    914.38   -$43.75


                             Cash     $28.26
                            TOTAL   $3960.64

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