Financial

A Stock Split Doesn’t Change Fundamentals But Could Boost Stock Price

Are you excited about a stock split? Don’t be. A stock split is simply financial engineering. Some retail investors get tricked into thinking they’re getting a better deal than they really are.

I still remember one of my VPs at Goldman making fun of an Associate one morning. The Associate excitedly shouted out to the team that a stock was on sale by 80% and that we should all buy!

Little did the Associate know the shares had just gone through a 5:1 stock split. Instead of trading at $50 a share, it was now trading at “only” $10 a share. The Associate got a good ribbing for the rest of his time at the firm.

What Is A Stock Split?

A stock split, also known as a forward stock split, is when a company increases the number of its shares to boost the stock’s liquidity. Although the number of shares outstanding increases by a specific multiple, the total value of all shares outstanding remains the same. The value of each share gets commensurately lower.

For example, let’s say a company has 100 shares outstanding and each share trades at $10 for a market capitalization of $1,000. The company announces a 2-for-1 stock split. As a result, the total shares outstanding rises to 200, while the price per share falls to $5. The end result is the same market capitalization of $1,000.

A stock split doesn’t fundamentally change the company’s value. The calculating of ratios like a company’s earnings per share, price to book ratio, EV/EBITDA, profit margins, and so forth are not altered by a stock split because everything is adjusted.

Why Would A Company Want To Do A Stock Split?

Here are the main reasons:

1) Make shares more attractive to retail investors.

When Google announced a 20-for-1 stock split, the share price was about $2,700. In other words, it would require a retail investor to spend over $2,700 just to buy one share. By splitting the stock 20-for-1, the price per share would fall to $135, a much easier hurdle to overcome.

By attracting more liquidity/capital from retail investors, it could boost the price of the company’s shares. The downside to artificially inflating a company’s share price is that the stock becomes more susceptible to earnings disappointments.

In the long run, it’s best if a stock price moves based on fundamentals, not based on financial engineering and hype. However, for short-term traders, stocks trading on hype often presents them an opportunity to profit.

2) Greater liquidity for better price discovery.

A higher number of shares outstanding leads to greater liquidity for the stock. Greater liquidity for the stock results in narrower bid-ask spreads and better price discovery. For example, if a stock has barely any liquidity, a buyer or seller can more easily affect the share price, which creates more volatility.

Greater liquidity enables companies to repurchase their shares at a lower average cost. Just imagine if the total volume traded a day was $100 million, but a company wanted to buy back $10 million of its stock. The share price would probably jump 10%+ once the market found out. However, if the total volume traded a day was $1 billion, a $10 million order bought throughout the course of the day wouldn’t move the needle.

For institutional investors that need to move big blocks of stock, greater liquidity also helps them minimize any price disruption. Block trading is quite common for large institutional investors, including massive index funds that need to rebalance whenever there are changes in the constituents.

As an investor in actively-run funds and private funds, you want to be careful not to invest in funds that are too large. A fund with $10 billion in assets under management is going to have a harder time finding deals other than larger capitalization companies. Whereas a fund that is $500 million can be more nimble.

3) Potential inclusion into a stock index

One of the reasons why a company might want to do a stock split is so that it increases its chances of getting included in a major stock index like the Dow Jones Industrial Average. It’s strange logic since a split doesn’t change a company’s fundamentals. An index such as the DJIA should be agnostic to a company’s share price or its number of shares outstanding.

However, the DJIA is a price-weighted index. As a result, a high stock price might preclude a company from getting in. With Google splitting its stock 20-for-1, its price is more in line with the other companies in the index. If Google gets into the DJIA, expect to see a lot more buying of the company’s stock from index funds and index fund investors.

Therefore, financial engineering does work. Just be careful around earnings time if a company’s share price is not mostly trading on company fundamentals.

Reverse Stock Splits Happen Too

A reverse stock split is the opposite of a forward stock split. A company carrying out a reverse stock split decreases the number of its outstanding shares and increases the share price proportionately.

As with a forward stock split, the market value of the company after a reverse stock split remains the same. A company would consider a reverse stock split to boost its ailing share price. Once a share price goes below a certain threshold for a certain period of time, it can get delisted from an exchange.

For example, the NASDAQ has three primary requirements to stay in compliance:

  • Share price of at least $1.
  • A total of at least 400 shareholders.
  • Shareholders’ equity valued at $10 million or a market value of at least $50 million or total assets and total revenue of at least $50 million each.

Some mutual funds may not invest in stocks priced below a present minimum price per share. Such logic may be grounded in the belief that lower-priced shares may be at greater risk of declining further. It’s a perception issue where investors begin to abandon stocks that trade far below the norm.

Again, financial engineering can help a company survive.

What Happens If You Own Shares that Undergo a Stock Split?

When a stock splits, it credits shareholders of record with additional shares, which are reduced in price in a comparable manner. On the day of the official stock split, your brokerage account will magically have more shares at the new price. There’s nothing you need to do.

Any Tax Implications After A Stock Split?

No. A stock split won’t affect your taxes. The tax basis of each share owned after the event will be adjusted accordingly.

You will only incur a capital gains tax when you sell a stock that is higher than your cost basis. Therefore, if you never want to pay capital gains tax, never sell. Borrow from your investments at a low rate instead.

Below is a curious video from TikTok on stock splits. The guy believes Google will gain $2 trillion more in market value in 3-6 months due to announcing their stock split. I guess anything is possible. However, his reasoning is flawed. If it was so easy to double your company’s valuation, every company would announce a stock split.

For people who are hesitant to create online, this video is a good example showing how anybody can do anything on the internet to gain a following and make money. You don’t have to be an expert. You just need to take action. It’s the people who do nothing but complain who make no money.

Stock Splits Are A Net Positive For Existing Shareholders

As a retail investor, you don’t mind your company announcing a stock split. Even though the fundamentals don’t change, you want your investment to attract more attention and more liquidity.

If the stock starts zooming higher based on financial engineering, you can then sell the stock for a profit. This is exactly what happened when I bought $3,000 worth of VCSY for $1/share in 2000. After gaining some momentum, the company announced a 20-for-1 stock split that propelled the stock higher by 45X!

Having your company announce a stock split is like getting a free call option. Usually, the share price will continue to trade on fundamentals once a split is announced. Further, a company shouldn’t get negatively affected by announcing one. However, there’s a chance the share price might move up based on renewed interest and increased liquidity.

A lot of meme stocks don’t trade on fundamentals. Instead, they trade on hype. Some stocks, like AMC and Gamestop, have done extraordinarily well as a result. Announcing a stock split creates more hype. And that’s temporarily a good thing if you’re long.

Stocks Splits Are More Impactful For Smaller Companies

The smaller the company, the more impactful a stock split to its share price. A million more interested investors with $5,000 each to invest can move the share price of a $1 billion market capitalization company more easily than a $1 trillion company. The challenge is finding such companies to invest in before they announce a split.

One of the most obvious stock splits that should happen is by Amazon. At over $3,000/share, Amazon’s share price may benefit from splitting the shares at least 10-to-1. I’m sure there are plenty of Amazon users who would love to own some stock.

Just remember that over the long run, a company will mostly trade on fundamentals. Company management knows this, which may be why highly-valued companies are hesitant to conduct any financial engineering. If management artificially makes their share price go up, their shares might get slaughtered with any earnings miss down the road.

Readers, do you own any stocks that are planning to do a stock split? Any other companies you think should do a stock split and potentially boost its share price?

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A Stock Split Doesn’t Change Fundamentals But Could Boost Stock Price is written by Financial Samurai for www.financialsamurai.com

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