Doing the Stock Splits
By Ann Coleman (TMF AnnC)
February 21, 2001
Q. What happens when a stock splits, and how does an investor benefit from it? -- S.A.C., via email
A. Want to see a grown customer service rep here at the Fool break down in tears? Ask one how to find stocks that will split so that your investment will double.
Then there's the guy who bought 100 shares at $10. The stock went up to $20 and split two-for-one so he sold 100 shares at $10. He wanted us to tell him he didn't have to pay capital gains tax on the sale. He thought he got a free pass on his capital gains tax even though his investment doubled. Uncle Sam has sooooooo seen that before.
Here's why the above fantasies won't work: Stocks splits are meaningless. A stock split is just an accounting adjustment. (That should be the kiss of death for anyone who thinks stock splits are glamorous!)
When a stock splits, two things happen. The number of "authorized shares" doubles (we are assuming a two-for-one split to keep things simple) and the price is cut in half. The price cut is retroactive, too. Your original cost for each share is halved.
A stock split is like getting two tens for a twenty. Big deal. If you had, say, 100 shares at $50 the day before a two-for-one split, the next morning when the market opens, the price will be halved and your broker will adjust your account to show that you own 200 shares at $25, which is $5000 -- exactly the same value as, you guessed it, 100 shares at $50.
Then why does everyone get excited about stock splits, even when they understand the math?
Even though a stock split adds no value to a stock, it can be a sign that a company is doing well. The faster a company grows, the more often it will split its stock to keep the price within a certain range. There's just one catch: Not every company that declares a split will continue to grow at its previous pace. I have personally watched two of my stocks split and then proceed to drop another 50-60%. Without looking into fundamentals, there's no way to tell if the company really is a good investment.
Sure, there are some very well-managed companies in hot industries that split and proceed to double within just a few months or years. So they split again and their shareholders rejoice, and they double again, and everyone buys yachts.
But somehow cause and effect have gotten switched in the public mind. Thinking that splits cause a stock to go up is like thinking that the sky growing lighter in the morning causes the sun to rise.
What now? What happens when a stock never splits? It can be impressive if the company is a strong one. A single share of Berkshire Hathaway class A stock (NYSE: BRK.A) is now selling for around $70,000.
Ann Coleman is a former Customer Service manager for the Fool. She transferred to Content after her 573rd stock split question, preserving her sanity and saving the lives of all who sat near her. She regrets owning not even a single share of Berkshire Hathaway. Stock she does own is listed in her personal profile.The Motley Fool is investors writing for investors.
Submit a question for Ask the Fool.