What does it mean when a company decides to do a stock split? For the company and existing shareholders, it actually doesn't change that much.
Stock splits simply adjust the number of ways ownership is sliced, they don't change the value of a company or the value an individual owner holds. That's because when a company announces a stock split, they give existing shareholders stock in proportion to their existing ownership to make them whole for the increase in share count.
If it doesn't change anything in terms of overall value, why do companies split their stock?
- Stock splits reduce the price per share, making it easier for new investors to become a shareholder of the company. This is partially why Apple (NASDAQ:AAPL) split its stock 7-for-1 in 2014.
- Splits also increase the number of shares outstanding, which can help with liquidity.
- Some special securities like options are sold in blocks of 100 shares, so if a company's stock price is very high, it requires a lot of money upfront to create these transactions.
For a full rundown, on stock splits, check out the video below!
A full transcript follows the video.
Dylan Lewis: Hey, I'm Fool.com editor, Dylan Lewis, and on this episode of FAQ we're going to talk pizza and stock splits. OK, I'm going to offer you two different options. You can have one slice of a 12-inch pizza that's been cut into quarters, or you can have two slices of a 12-inch pizza that's been cut into eighths. Which one do you choose? Think about your answer. While you do, let's walk through what a stock split is.
All companies that are publicly traded, have a certain number of shares outstanding. Let's say I have a publicly traded company that's worth $1 million and ownership of that company is divided into 10,000 shares outstanding. So, each share is worth $100. Now, let's say my company puts up some awesome business results. We release a bunch of new products. Those products sell really well and customers are happy. Thanks to the massive boost in sales over a few years, the business grows to $10 million in value. Now, each share is worth $1,000, at this point. As management, I might look at that and say, "You know, that's a lot of money that people need to have in order to become a shareholder of my company. I want to make sure that the average person can buy one share and become an investor. If that's the case, I might decide to do a stock split. Say I do a five for one split. One share, now, becomes five. So, the total shares outstanding will become 50,000 for the company, and the price of each share will go from $1,000 to $200. The total value of the business stays the same. The total value each shareholder holds stays the same. The only thing that changes is the number of shares and how much they're worth. That five for one example was for the sake of round numbers and my math skills, but most stock splits are either two for one or three for two.
Now, you might be thinking: "Why? If stock splits do nothing for the value, why do companies do them?" Well, companies might decide to do it to make it easier for the average investor to buy shares. If someone is trying to save $100 per month to invest, they have to wait a lot longer to buy shares if they want to buy shares that are priced at $1,000 instead of $50. This was the main reason Apple decided to go through a seven for one stock split a few years ago. Apple CEO, Tim Cook, said in 2014: "We're taking this action to make Apple stock more accessible to a larger number of investors."
Companies will, also, do this because there are some special securities, like options, that are sold in lots of 100. We'll talk about options on a future episode, but for the purposes here, just know that they generally need to be sold in blocks of 100 shares. So, if a company's stock price is very high, it requires a lot of money upfront to transact these options. Like the previous reason, companies might split their stock to make it easier for people to do that. One third reason that you'll see companies go through a stock split is that it increases the number of shares outstanding, meaning there are more available shares to trade, which can help with liquidity. There are actually some companies that intentionally avoid splitting their stock, and the main reason: stock splits are cosmetic changes to a company's ownership. They don't change the fundamentals of the business at all, and a high share price tends to attract long-term buy-and-hold investors and it actually makes it harder for people to short-term trade in and out of a company. This quote, from Warren Buffett's 1993 annual letter to Berkshire Hathaway (NYSE:BRK-A) (NYSE:BRK-B) shareholders, pretty much sums it up: "Were we to split the stock or take other actions focusing on stock price rather than business value, we would attract an entering class of buyers inferior to the exiting class of sellers. Could we really improve our shareholder group by trading some of our present clear-thinking members for impressionable new ones who, preferring paper to values, feel wealthier with nine $10 bills than with one $100 bill?" Buffet ultimately caved and created a separate class of Berkshire shares and a split, but he has never split the voting Berkshire A shares, which currently trade at over $300,000 each.
More management teams are starting to think like Buffett. In 1997, over 100 companies in the S&P 500 split their stocks. In 2016, that figure was down to seven. Executives are wising up to the fact that stock splits are not worth their time and the rise of brokerages offering fractional shares have made it easier for investors with less money to, still, get into the market. You'll hear people say, "Oh, stock splits are a bullish sign. It means the company thinks they're going to keep growing and the share price is going to keep going up." No! It's just shuffling around how ownership is held.
Going back to our pizza example, some people might prefer to get two smaller slices instead of monster piece of pizza. The reality is you're getting the same amount of pizza, either way. The same goes for a stock split. There may be some short-term movements related to the news, but long-term, shares move because of the business results that companies put up, not the number of ways ownership is sliced up.
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