In case you've been living under a rock and missed the hundreds of articles, discussions, and analyses of the Apple (AAPL -2.11%) stock split, shareholders now have seven times as many Apple shares in their trading accounts. This occasion seems like a good opportunity to discuss the basics of what exactly a stock split is and why Apple shareholders should be happy about it.
Why would a company issue a stock split?
Sometimes, the stock of a company like Apple will climb so high that its price is hard to afford for many average investors. Rather than allowing high prices to discourage buyers, the company will issue a stock split.
When a company issues a stock split, they are literally splitting the shares of stock into pieces. For example, the recent Apple stock split was 7:1. If you owned 10 shares at $644 per share before the split on Friday, you owned 70 shares at $92 per share on Monday morning.
Since the pizza analogy has been beaten to death, let's use an apple pie: more slices does not mean more pie. The market cap of Apple did not change. Notice that there is no inherent value creation or destruction that results from the split itself: before the split you owned $6440 worth of stock, and after the split it is still $6400 worth of stock until trading starts on the day of the split.
Why is a stock split a good thing?
Stock splits are generally seen as a good thing for investors for two main reasons.
- The stock split lowers the cost of shares and psychologically makes the shares seem more appealing to investors.
- A company usually only issues a stock split if its share price has risen significantly in the past. Therefore, a company issuing a stock split likely has a stellar performance history.
So there you have it. Despite the fact that the split itself does not directly create value for shareholders, it's typically a good thing. From the Wall Street Journal:
Several studies have found that the average stock undergoing a split outperforms the overall market by a significant margin over the three years following the company's announcement of that split.
A word of caution to Apple shareholders
Before Apple shareholders get too excited about the stock getting to $120 in the next month, it's important to understand two caveats to Apple's stock split scenario:
- Post-split stocks tend to outperform the market. Outperforming the market could mean that the stock gains 10% while the market gains 5%. Or it could mean the stock loses 5% while the market loses 10%. The stock market does not rise in perpetuity without corrections and bear markets along the way.
- Apple announced this stock split nearly two months ago.
For the sake of a smooth transition, the prices on this chart prior to the split have been adjusted to the post-split share count (by dividing by seven). As you can see, the stock was up more than 20% in the past three months prior to the split. This climb makes sense because lots of people want to buy before the split happens expecting that the split will lead to a rise in share price.
This anticipatory buying drives the price up before the split actually takes place. Notice that the Wall Street Journal article specifically referenced the date of the "announcement" of the split rather than the date on which the split actually occurs.
What does the post-split future hold?
Apple's strong fundamental picture includes a relatively low valuation, continuing revenue growth, massive buybacks, and major expansion into China via China Mobile.
Apple's lower post-split share price and expected upcoming line of product launches should continue to drive the price higher over time, but shareholders shouldn't freak out if the next couple of weeks aren't as rosy as everyone seems to assume they will be. Don't be surprised to see some short-term Apple traders with high expectations lose patience and sell in the upcoming weeks. But after any short-term traders are flushed out, the stock should be free to follow the upward trend that most fundamentally strong stocks exhibit in the years after a stock split.
