When a company decides to sell or distribute an existing subsidiary or division as a new independent company, it is called a spinoff. A recent example was the creation of PayPal, which started trading as an independent company after it was spun off from eBay in July. Here's what you need to know about spinoffs' effect on stock prices.

Why companies choose to do a spinoff
There is a variety of reasons a company may want to spin off a portion of its business. For instance, if a portion of its business is heading in a completely different direction and has different strategic priorities, allowing this portion to operate independently can unlock value.

This was the main reason for the eBay/PayPal split. eBay and PayPal were heading in different directions, and creating two independent entities allow the directors of each to focus on their core operations instead of worrying about a broader spectrum of business activities.

Plus, spinoffs allow investors to buy shares in a more specific type of business that fits their investment objectives. For example, if someone wants to add a financial company, they can now buy shares of just PayPal without simultaneously investing in eBay's e-commerce business.

Whatever the reason for a particular spinoff, the common ground is that management feels the company will create more shareholder value with the assets separated.

The stock price: before and after
A company's stock price after completing a spinoff depends on whether any of the spun-off entity was retained.

In a complete spinoff, the stock price of the company right before the spinoff should theoretically be equal to the sum of its post-spinoff stock price plus the initial stock price of the spun-off company. For example, if a company whose stock trades for $50 spins off a subsidiary in its entirety at an initial price of $20 per share, its stock price should theoretically fall to exactly $30. Of course, because stock prices are continuously changing in a liquid stock market, it's unlikely to be exactly equal to the original share price minus the spun-off share price, but it should be close.

If the parent company retains a portion of the spun-off entity, it's a little more complicated.

Let's consider an example of a company whose market capitalization is $10 billion with 100 million outstanding shares, which translates to a share price of $100. And let's also say that this company wants to spin off 50% of one of its business divisions, which is valued at $2 billion, at an initial share price of $20 (100 million shares).

Well, because the parent company is retaining 50% of the spun-off company, its share price should be equal to the value of its business, plus the retained 50% stake in the spun-off division. In this case, the remaining part of the parent company is worth $8 billion, or $80 per share, and the 50% stake in the spun-off entity is worth $1 billion, or another $10 per share, for a total (theoretical) post-spinoff share price of $90.

Spin-offs are reflected on your brokerage statement, and each broker has different formats. If you're looking for a broker whose statements meet your needs, visit our broker center for additional info.

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