By Brian Nelson, CFA
There are few financial topics more misunderstood, in my opinion, than stock splits. Some investors believe that a stock split is a value-creating endeavor brought about by “market forces” that have blessed their company’s stock for one reason or another. They believe that they will get more shares of the company at the same price, thereby doubling their investment value as a result.
Unfortunately, this is not correct. In reality, a stock split is a move made at the complete discretion of the company’s board to reduce the nominal price of the company’s shares such that more individual investors can “afford” to buy more of the stock (increasing its ownership base). The primary reason stems from the common belief that (psychologically) the individual investor has an easier time digesting the purchase of, let’s say, 100 shares of stock for $10 each than the purchase of 1 share of stock for $1,000–even though both of the cash outlays are equivalent to $1,000.
As we’ll show below, a stock split does nothing to create fundamental economic value for the company and is nothing more than a superficial move akin to that of cutting a $100 bill in half: no matter how many times you cut the bill, it’s still only going to be worth $100. In stock-market parlance, a company is worth the same market capitalization (its aggregate price) no matter how may slices (shares) are outstanding. For example, when a 2-for-1 stock split is executed, the number of shares are increased by a factor of 2, while the price of these shares is reduced by half, preserving the original market capitalization (price) of the firm (all else equal).
Market Capitalization (total price of the company) = Price per Share x Shares Outstanding
Let’s walk through an example. In December 2013, Mastercard (MA) announced a 10-for-1 stock split. Effectively, holders of Mastercard’s stock received 9 additional shares for each share they held as of a certain date, the record date (in this case, the record date was January 9, 2014). On the date following the ex-split date (January 21, 2014), the number of Mastercard shares outstanding increased 10-fold, and the initial price of Mastercard’s stock was reduced by a factor of 10. Specifically, total shares of common stock outstanding increased from approximately 120 million to 1.2 billion as a result of the move, and the price of the firm’s stock was reduced from $818.48 to $81.848.
Let’s see what happened to Mastercard’s market capitalization as a result of this move:
120 million x $818.48 = $98,217.6 billion
1.2 billion x $81.848 = $98,217.6 billion
It becomes obvious when walking through the calculation that Mastercard, in performing the stock split, has merely decided to divvy up the company into smaller pieces–and that no aggregate value has actually been created. Holders of Mastercard’s stock simply received 10 times as many shares, and the individual shares of stock were reduced to one-tenth of the pre-split price. Mastercard, the company, is not worth one-tenth of its pre-split value–only the company’s individual shares are after the split. Holders of Mastercard’s shares are made whole because they now own ten times as many shares as before. The total value of their positions in Mastercard has not changed. Mastercard’s intrinsic value calculation is adjusted in similar fashion: the number of shares outstanding is increased by a factor of 10, reducing the fair value estimate per share of the firm to one-tenth of its pre-split value.
Note: At times the announcement of a stock split may generate interest in the firm as a result of the psychological dynamic noted above: Investors tend to like stocks that don’t trade for hundreds or thousands of dollars per share and feel more comfortable with comparatively lower-priced stock. This may cause the shares of a company that has announced a stock-split to rise temporarily (due to buying activity), but no economic value has actually been created by the company as a result of the announcement.
Valuentum’s Take
Just like you can’t create more money or add value by cutting a $100 bill in half, companies can’t create value by performing stock splits. After the ex-split date, the fair value estimate per share of Mastercard was adjusted downward by a factor of 10. In all cases, the size of the fair value estimate adjustment depends on the details of the stock split. For example, 2:1 stock splits result in the fair value estimate being halved, while 7:1 stock splits result in the fair value estimate being reduced by a factor of 7, and so on. We hope this article helps clarify one of the most misunderstood topics in finance. Thanks for reading!
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A version of this article appeared on our website December 12, 2013.
Brian Nelson owns shares in SPY, SCHG, QQQ, DIA, VOT, BITO, RSP, and IWM. Valuentum owns SPY, SCHG, QQQ, VOO, and DIA. Brian Nelson’s household owns shares in HON, DIS, HAS, NKE, DIA, and RSP. Some of the other securities written about in this article may be included in Valuentum’s simulated newsletter portfolios. Contact Valuentum for more information about its editorial policies.
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